The Goldman "fraud" case

The SEC says that Goldman should have told the sophisticated institutional investors who bought the Abacus synthetic CDO that there was someone else on the other side of the trade. By this logic, when you buy a stock, the broker must inform you that someone else is selling the stock. The logic is so twisted that one does not know where to begin. But someone else has taken this on: Sebastian Mallaby at the Washington Post.

In SEC vs. Goldman, who's really at fault?

Let's stipulate that there's a problem with the power of Goldman Sachs. The firm takes vast risks and earns vast profits; then, when it gets into trouble, as it did after the Lehman Brothers failure, it turns to the government for a bailout. But the case the Securities and Exchange Commission has brought against Goldman also involves a problem. Unless the SEC is sitting on more evidence than it has laid out so far, the charge sheet looks flimsy. If Goldman has become a poster child for excessive power on Wall Street, the SEC might become a poster child for government power run amok.

The SEC's 22-page complaint states that Goldman sold fancy mortgage securities without disclosing that a hedge fund manager, John Paulson, was betting that those same securities would go bad. This is a non-scandal. The securities in question, so-called synthetic collateralized debt obligations, cannot exist unless somebody is betting that they will lose value. The firms that bought Goldman's securities knew perfectly well that some other investor must be taking the opposite position. It was their job to evaluate the Goldman offer and make up their own minds. One of the big losers in the deal was IKB, a German bank with a big business in mortgages. We're not talking mom and pop.

Perhaps the SEC is suggesting that Paulson's involvement changes this logic, because the hedge fund manager is famous for making billions from his mortgage bets? There's a superficial case here: Even if investors don't mind that somebody else is on the other side of the trade, maybe they wouldn't want to bet against a superstar. But at the time of the deal, Paulson was a low-profile player whose name would not have set off alarm bells. And intermediaries like Goldman are not supposed to blab about the identities of their clients.

Next, the SEC complains that Paulson had a hand in designing the securities, maximizing the chances that they would blow up. He did the equivalent of building a timber house with a large fireplace and a blocked chimney, then buying fire insurance on the structure. Shocking though this may sound, it is another non-scandal. An investor who wants to bet against a bundle of mortgages is entitled to suggest what should go into the bundle. The buyer is equally entitled to make counter-suggestions. As the SEC's complaint states clearly, the lead buyer in this deal, a boutique called ACA that specialized in mortgage securities, did precisely that.

Finally, the SEC asserts that Goldman, and specifically its young mortgage whiz, Fabrice "Fab" Tourre, tricked ACA into believing that Paulson meant to bet on the mortgages' soundness, not the other way around. This is the nub of the case, and if there's proof that Goldman or Tourre was dishonest, the SEC could yet emerge with its reputation intact. But none of the e-mail fragments quoted in the complaint comes close to being a smoking gun.

What the complaint does show is that ACA believed Paulson was a buyer, not a seller; and the really intriguing mystery is how ACA could have been so dumb. As the deal was taking shape, ACA and Paulson met repeatedly. If ACA had any doubt as to Paulson's intentions, surely it could have asked him a straight question rather than relying on alleged hints from Goldman. Throughout the negotiations, Paulson kept proposing notoriously low-quality mortgages for the bundle and vetoing high-quality ones. It should have been obvious to ACA that he meant to bet that they would go down.

The worst that can be said on the basis of the available evidence is that Goldman knew ACA was being stupid and failed to point this out. That falls far short of the offenses that the SEC alleges, which might be why two of the SEC's five commissioners refused to vote for the action against Goldman -- a rare split in an enforcement case. And yet, rather than treat the SEC's adventure with due caution, politicians and regulators are jumping on the bandwagon. British Prime Minister Gordon Brown, who just happens to be fighting an election campaign, has pushed British regulators to pile on to the SEC case. German Chancellor Angela Merkel, who could use some market scapegoats to distract from the euro zone's debt crisis, is threatening to follow suit. Congressional investigators are planning to grill Goldman officials for the umpteenth time.

Much is wrong on Wall Street, and Congress should pass some version of the regulatory package that is bottled up in the Senate. But the premise for more regulation is that the regulators will behave responsibly. Let's hope the SEC remembers that.

Questions about Europe and the outlook for global growth

The bad scenario that the EZ is trying to avoid is a Greek default, leading to contagion in other weak EZ members. While the EU probably has the resources to rescue both Greece and Portugal, it does not have the resources to rescue Italy or Spain. So here are some questions:

• Can Greece regain market access over a reasonable time period, such that the EU does not have to assume all of its debt?
• As Greece's bonds decline in price and its ratings continue to decline will banks have to begin to take writedowns this fiscal year?
• If Greece cannot regain market access (and most observers are skeptical), will the EU be willing or able to refinance all EUR 300 billion of Greece's sovereign debt as it matures?
• If the bailout becomes a protracted affair, what would happen if Greece failed to meet its fiscal targets (as is very likely)?
• Assuming that Greece is supported for this year, is that enough time for Portugal, Spain and Italy to show sufficient progress toward their deficit reduction targets such that they keep market access?
• If Greece ultimately defaults and contagion spreads to one or more other EZ members, what is Plan B?
• In the event of one or more EZ government defaults, what are the implications for the exposed banks in France and Germany?
• Can a firewall be drawn around the northern European banks in the event of major government defaults?
• Will the ECB be willing to engage in unorthodox manoeuvres in order to offset the deflationary impact of either (a) massive fiscal consolidation in the EZ and/or (b) sovereign defaults?
• If not, what is the outlook for nominal GDP growth in Europe over the medium term?
• And what are the implications for global growth given this situation?
• Can the US grow while Europe shrinks?

The future of an illusion

Right now, we have a national consensus that bank bailouts are a "waste of taxpayers' money". 

It seems that the only public voice of reason on this issue is Paul Krugman who understands that (1) bailouts are necessary, and (2) that the Senate Republicans are demagoging this issue in order to prevent stricter regulation.   

Wall Street is willing to take the risk that bailouts will be prohibited in order to avoid the regulation that would make them less likely in the future. 

We need much better regulation, and we need the government to be able to intervene to prevent a 1930-33 catastrophic meltdown of the financial system. 


The TARP was the best investment this country has ever made. Basically, we paid a few billion dollars in order to prevent a massive contraction in GDP, incomes and tax revenue. Without the TARP, the deficit and the national debt would be much larger, and growth prospects much worse.

The way to deal with moral hazard is prudential supervision, not a laissez-faire attitude toward financial stability.

Below, verbatim, is Krugman's column from today's NYT:

On Tuesday, Mitch McConnell, the Senate minority leader, called for the abolition of municipal fire departments.

Firefighters, he declared, “won’t solve the problems that led to recent fires. They will make them worse.” The existence of fire departments, he went on, “not only allows for taxpayer-funded bailouts of burning buildings; it institutionalizes them.” He concluded, “The way to solve this problem is to let the people who make the mistakes that lead to fires pay for them. We won’t solve this problem until the biggest buildings are allowed to burn.”

O.K., I fibbed a bit. Mr. McConnell said almost everything I attributed to him, but he was talking about financial reform, not fire reform. In particular, he was objecting not to the existence of fire departments, but to legislation that would give the government the power to seize and restructure failing financial institutions.

But it amounts to the same thing.

Now, Mr. McConnell surely isn’t sincere; while pretending to oppose bank bailouts, he’s actually doing the bankers’ bidding. But before I get to that, let’s talk about why he’s wrong on substance.

In his speech, Mr. McConnell seemed to be saying that in the future, the U.S. government should just let banks fail. We “must put an end to taxpayer funded bailouts for Wall Street banks.” What’s wrong with that?

The answer is that letting banks fail — as opposed to seizing and restructuring them — is a bad idea for the same reason that it’s a bad idea to stand aside while an urban office building burns. In both cases, the damage has a tendency to spread. 

In 1930, U.S. officials stood aside as banks failed; the result was the Great Depression. In 2008, they stood aside as Lehman Brothers imploded; within days, credit markets had frozen and we were staring into the economic abyss.

So it’s crucial to avoid disorderly bank collapses, just as it’s crucial to avoid out-of-control urban fires.

Since the 1930s, we’ve had a standard procedure for dealing with failing banks: the Federal Deposit Insurance Corporation has the right to seize a bank that’s on the brink, protecting its depositors while cleaning out the stockholders. In the crisis of 2008, however, it became clear that this procedure wasn’t up to dealing with complex modern financial institutions like Lehman or Citigroup.

So proposed reform legislation gives regulators “resolution authority,” which basically means giving them the ability to deal with the likes of Lehman in much the same way that the F.D.I.C. deals with conventional banks. Who could object to that?

Well, Mr. McConnell is trying. His talking points come straight out of a memo Frank Luntz, the Republican political consultant, circulated in January on how to oppose financial reform. “Frankly,” wrote Mr. Luntz, “the single best way to kill any legislation is to link it to the Big Bank Bailout.” And Mr. McConnell is following those stage directions.

It’s a truly shameless performance: Mr. McConnell is pretending to stand up for taxpayers against Wall Street while in fact doing just the opposite. In recent weeks, he and other Republican leaders have held meetings with Wall Street executives and lobbyists, in which the G.O.P. and the financial industry have sought to coordinate their political strategy.

And let me assure you, Wall Street isn’t lobbying to prevent future bank bailouts. If anything, it’s trying to ensure that there will be more bailouts. By depriving regulators of the tools they need to seize failing financial firms, financial lobbyists increase the chances that when the next crisis strikes, taxpayers will end up paying a ransom to stockholders and executives as the price of avoiding collapse.

Even more important, however, the financial industry wants to avoid serious regulation; it wants to be left free to engage in the same behavior that created this crisis. It’s worth remembering that between the 1930s and the 1980s, there weren’t any really big financial bailouts, because strong regulation kept most banks out of trouble. It was only with Reagan-era deregulation that big bank disasters re-emerged. In fact, relative to the size of the economy, the taxpayer costs of the savings and loan disaster, which unfolded in the Reagan years, were much higher than anything likely to happen under President Obama.

To understand what’s really at stake right now, watch the looming fight over derivatives, the complex financial instruments Warren Buffett famously described as “financial weapons of mass destruction.” The Obama administration wants tighter regulation of derivatives, while Republicans are opposed. And that tells you everything you need to know.

So don’t be fooled. When Mitch McConnell denounces big bank bailouts, what he’s really trying to do is give the bankers everything they want.

European dominoes

After Greece goes, the bond-market will round on another wounded eurozone sovereign, undoubtedly Portugal.

Mohamed El-Arian in the FT:

Buoyed by a cyclical recovery, markets around the world have yet to recognise the complexity of this situation. When they do, it will also become apparent that Greece is part of a wider, and historically unfamiliar phenomenon – that of a simultaneous and large disruption to the balance sheet of many industrial countries. Tighten your seat belts.

One way or another, this spiralling crisis will force weak countries to balance their budgets, either in response to the risk of loss of market access or default. That means that much of Europe will face a Great Depression scenario: deflationary fiscal policy in the face of economic recession. 

As Krugman pointed out in today's NYT, fiscal contraction in the face of deflationary monetary policy can only lead to disaster. Will the ECB cushion this blow, or will it do what the Fed did in the early thirties? And if it does pursue deflation, can it survive as an independent institution?

Will the Greek safety net work?

The EU/IMF "safety net" for Greece is intended to make it possible for Greece to refinance its maturing bonds and thus preempt the need for the net to be drawn upon. While it is too soon to judge whether this maneuver will satisfy the bond market, so far it hasn't. 

Much will depend on the scale of the package in relation to the Greek debt calendar. It is very unlikely that the package will be equal in size to Greece's maturing debt in 2010-11. The package is said to be about EUR25 billion, while the Economist estimates that Greece needs at least EUR75 billion. 

Any rescue requires the unanimous consent of all 27 EU members, which is not a given.

Greece needs its spreads to come in by at least 200bps; so far it has tightened by ~20bps.

The ECB has relaxed its collateral eligibility requirements for 2010-11, so that Greek bonds would still be eligible for discount in the event of a ratings downgrade by Moody's. The ECB has not revealed the amount of Greek debt that it has taken as collateral (or owns outright), and may come under pressure to do so.

A larger question is whether risk managers will continue to tolerate large exposures to Greece, or will reduce concentration limits on all things Greek. I can't imagine that this is not happening globally. 

The things to look for over the next months are:

• The scale of the package
• Political developments in Greece
• Greek fiscal performance
• Bond and swap spreads

The no-bailout clause of the Lisbon Treaty

Article 125 of the Lisbon Treaty (2007):

• The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. 
• A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

Germany sets conditions for Greek rescue

Berlin has indicated what conditions it would require to participate in a Greek rescue. Germany as come under a lot of pressure to come to Greece's aid, while facing huge opposition at home. It appears that Merkel's solution is to agree to consider aid while setting impossible conditions. There is simply no way that the EU treaty can be renegotiated at all, let alone quickly.

From today's FT:

A senior government official in Berlin said there would be no agreement at this week’s EU summit on a specific rescue package for the debt-strapped Greek government. If there were to be agreement on a “mechanism” to provide such assistance, he said, it could only be triggered once Greece had exhausted its capacity to raise money on the international capital markets; the IMF had agreed to make a “substantial contribution” to a rescue package; and the EU members had agreed to negotiate new rules to prevent any reccurrence of such a debt crisis. The German demand that could meet the most resistance from its EU partners is the insistence that new rules to enforce budget discipline should be negotiated, even if that requires treaty changes. Both France and the UK are passionately opposed to any such suggestion of reopening treaty negotiations.

So it would appear that Berlin's conditions are impossible. This does not mean that Greece will ultimately be allowed to default, but it does suggest that a swift and harmonious rescue will be difficult to achieve.

Greece 1898

From today's NYT:

The year after Greece lost another war against the Ottomans, Germany joined five other European powers in imposing the International Financial Commission on Greece in 1898. The commission controlled customs duties at ports including Piraeus and Corfu; state monopolies for products such as kerosene, matches and playing cards; and duties on stamps and tobacco consumption, all to ensure that Greece continued repaying its loans.

Those were the days. That was when "conditionality" really meant something.

Greece bond sale a success

Well, much to my surprise the Greek bond sale was oversubscribed (albeit at a high yield of >6%). This seems to me to bring the crisis from a boil to a simmer. It is not clear to what the success of the deal is attributable.


Possible reasons are: (1) markets find the austerity package to be credible; (2) markets think the package is credible enough to allow Greece to be rescued; or (3) markets have concluded that, willy-nilly, Greece won't default.

It appears that Prime Minister Papandreou believes that the answer is #2: that the package is credible and therefore merits European help.

Here is what he said today:
Let me be absolutely clear: Greece is not asking for a penny from German taxpayers. We are asking for political support, not financial aid. Currently, Greece has to borrow at interest rates almost twice as high as Germany and other EU countries. Greece must be able to borrow at rates that are not as prohibitively high. Otherwise we will have a difficult time implementing our tough austerity measures. My government is determined to overcome the huge credibility and budget deficit that we inherited.

His view is that market access is not enough; Greece needs market access at reasonable rates. He's undoubtedly correct: Greece's interest burden is too high already without high-yield credit spreads on top of it.

So the ball would now seem to be squarely in Merkel's lap. Reports are that the Germans and the French have a plan in mind, but want to wait at least a few weeks so that (1) the Greeks actually implement their plan, and (2) German public opinion can be brought around.

Papandreou is still in total denial about who caused this crisis: it's not the deadbeat looking for a guarantee, it's the debt markets:
Greece is being attacked by speculators who are putting the entire European project at risk. We need greater coordination and better regulation in order to protect our monetary union from speculation. Greece is the latest--but surely not the last--casualty of leaving financial markets unregulated. While Greek pensioners and civil servants are asked to accept drastic pay cuts, speculators are making billions every day on the back of Greece's problems. This is not about politics, this is about profits.

The Merkel plan won't work

Let's assume that Germany and France can cobble together a support package for Greece. A few eurozone governments will direct their state banks (such as KfW) to guarantee Greek government bonds, which would then be AAA and readily marketable. Sort of a Fannie Mae for Greece.



In theory, this will get Greece over the hump and buy time for it to bring its fiscal deficit under control. Then Greece would be able to access the debt markets on its own and maybe even refinance the guaranteed bonds.


I just don't see how this can succeed in the long run.


One, Greece's expense and revenue trajectories are such that only a deep and sustained depression can bring them into balance, which is politically impossible. (Greece will balance its budget only when it can no longer borrow.)


Two, Greece will not be able to return to the private debt markets anytime soon.


Three, this means that the EU (really the EZ) will have to finance not only Greece's deficits into the foreseeable future, but will also have to refinance maturing debt, until finally all of Greece's debt has been guaranteed by the EZ.


Fourth, the political will in Germany to engage in anything like this is very low.


My prediction is this:


The Merkel manoeuvre succeeds in preventing a crisis at this time.


By the fall, it becomes clear that Greece cannot implement an adequate austerity plan to satisfy the markets or the rating agencies.


Rating downgrades render Greek government bonds ineligible for discount at the ECB and toxic in the debt markets.


Europe would then be confronted with the choice of default or full responsibility for Greek finances (and funding needs).