The SEC has been a little lax lately. For example, they rejected warning after warning that Bernie Madoff was running a Ponzi scheme. So today’s announcement of a civil case against Goldman Sachs for fraudulently playing both sides of specific subprime mortgage investments comes as a bit of a shock. And it’s an even bigger shock when you reflect that what Goldman did was a microcosm of what Wall Street did to America. If what Goldman did was wrong – and it was – then what Wall Street did was wrong. The collapse of the world banking system wasn’t something that can be pinned on one rogue professional entity like Arthur Andersen in the Enron affair. The “entity” in this case was the whole top tier of the American banking system. It’s not that they’re too big too fail. The fact is, they’re too corrupt to live.
Goldman is accused of packaging and selling to investors some really shitty subprime garbage that had been packaged up for them by hedge fund manager John Paulson. The SEC says it was fraud because Paulson was betting AGAINST the very package of subprime mortgages that he had put together for the Goldman client to supposedly make money on. And this ability to sell garbage short was the whole key to the fantastic collapse as Michael Lewis tells it in the best book yet on the crisis, called The Big Short.
The key to the whole scheme lay in credit default swaps (CDS), the form of FAKE INSURANCE that was invented by the mathematicians and physicists at J.P. Morgan at an offsite retreat in the mid-‘90s. These bright boys thought that they had found ways to combine different levels of risk in a single instrument so that the instrument as a whole would be essentially risk free. But this concept had all the intellectual integrity of a betting formula -- one of those systems of betting on craps or roulette that 17th Century mathematicians were always inventing. These betting formulas always worked -- until they failed. And when they failed they failed catastrophically almost always due to the rude intrusion of some real world parameter that the mathematicians had failed to include in their formula -- like the house limit in craps, for example. CDS were like a betting formula -- they were fraudulent even though they seemed to be highly mathematical and highly sophisticated. Not only that, they worked for quite awhile. And this whole fake insurance market existed in the invisible world -- thanks to Phil Gramm and Robert Rubin, who steered a law through Congress that exempted these instruments almost entirely from regulation. Did the captains of the universe on Wall Street know these CDS's were phony? They had to know. They had to know the "insurance" was fake, because there were no adequate reserves for losses and no adequate underwriting. These guys know about risk.
Some very smart people early on realized that they could buy insurance against the dreadful subprime mortgages that were being bundled by the big Wall Street banks. One of these very smart people was Mike Burry, the neurologist who founded his own hedge fund. He was astounded to discover that Wall Street was selling CDS “insurance” on even the worst of these subprime bundles. And because the junk was rated AAA, Burry found that he could buy the insurance as cheaply as if he were buying insurance on a high grade bond. As Michael Lewis put it: “It was if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house in the mountaintop.” So Burry studies the arcane esoteric bundled subprime packages, found the worst of the worst, and bet HUNDREDS OF MILLIONS of dollars that they would fail. He made billions for his investors and himself.
Now what the SEC is telling us – what we already knew – is that some of the biggest banks on Wall Street were themselves selling these subprime packages short. What makes their acts despicable – and Mike Burry’s merely clever – is that the banks were both packaging this subprime garbage for their clients as if they were legitimate investment instruments with AAA ratings – AND they were selling them short by buying credit default swaps to cover them.
The whole thing was like a Ponzi scheme, and it needs to be prosecuted like a Ponzi scheme. And above all it’s time to shine the light of the investigation onto the New York Federal Reserve who was in the catbird’s seat throughout the colossal collapse. The chairman of the board of the New York Fed during the crisis was on the board of Goldman Sachs. One of the class A directors of the New York Fed – in essence, Timothy Geithner’s boss – was Jamie Dimon, CEO of J.P. Morgan. Dimon talked Geithner into committing $30 billion to cover the worst investments in the Bear Stearns portfolio – and no paper, no cable or network news program, mentioned this gigantic conflict of interest. No one mentioned that the banks that benefited most dramatically from the bailout were the banks that control the New York Fed.
This requires more than the SEC. I’d say appoint Eliot Spitzer and Patrick Fitzgerald as special prosecutors to investigate the greatest Ponzi scheme in history. It’s either that or lay down and die.