{"id":852,"date":"2010-04-20T13:21:53","date_gmt":"2010-04-20T13:21:53","guid":{"rendered":"http:\/\/scientopia.org\/blogs\/goodmath\/2010\/04\/20\/shocking-fraud-from-financial-scum\/"},"modified":"2017-04-06T11:36:07","modified_gmt":"2017-04-06T15:36:07","slug":"shocking-fraud-from-financial-scum","status":"publish","type":"post","link":"http:\/\/www.goodmath.org\/blog\/2010\/04\/20\/shocking-fraud-from-financial-scum\/","title":{"rendered":"Shocking Fraud from Financial Scum"},"content":{"rendered":"

Against my better judgement, I’ve ended up writing a lot about the
\nfinancial mess that we’re currently going through. If you’ve read that, you
\nknow that my opinion is that the mess amounts to a giant pile of fraud.<\/p>\n

But even having spent so much time reading and studying what was
\ngoing on, the latest news from the financial mess shocks<\/em> me.
\nEven knowing how utterly sleazy and dishonest many people in the financial world
\nhave been, even knowing about the stuff they’ve been doing, the kinds of
\nout and out fraud that they’ve perpetrated, the latest news makes them
\nlook even more<\/em> evil than I could have imagined.<\/p>\n


\n Let’s start by reviewing a bit.<\/p>\n

The basic thing at the root of the problem is something called a
\ncollateralized debt obligation<\/em> – CDO. A CDO is basically a share of a
\ngreat big bunch of loans, where the loans are backed by a piece of property.
\nThe most common form of CDO is basically a wrapper around a batch of
\nmortgages.<\/p>\n

Mortgage-based CDOs were traditionally a really safe investment. People
\nwill go to great lengths to avoid losing their homes – so an investment
\nthat would only lose money if people lost their homes was pretty solid.
\nIt became a hugely popular thing to invest in – and a hugely profitable
\nthing for the bank to sell.<\/p>\n

The problem was, there were more people who wanted to buy mortgage based
\nCDOs than there were mortgages to bundle into CDOs. So banks started looking
\nfor ways to make more mortgages. They’d already gotten people who could really
\nafford houses to take out mortgages. So they needed to find some other way of
\ngetting people to take out more<\/em> mortgages. They came up with a whole
\nbunch of schemes that let people do things like borrow more money than they
\ncould afford to pay back; or that gave mortgages to people with bad credit.
\nThey did pretty much anything they could possibly do to find ways of getting
\nmore mortgages to bundle up and sell. It got to the point where they would
\ngive people huge mortgages with no<\/em> documentation. You didn’t need to
\nshow that you were buying a house that was worth what you were borrowing; you
\ndidn’t need to show any evidence that you had an income. Nothing.
\nRealistically, no one actually expected these things to get paid off. But they
\ndidn’t worry about it: they just bundled them up for sale. In order to sell
\nthem, they structured them into packages that made these very risky things
\nlook safe. The main trick was something called tranching<\/a>.<\/p>\n

Tranching takes the mortgage bundle, and divides it into tiers. When loans
\nget repaid, the top tier gets repaid first<\/em>. Only once the top tier
\nhas been entirely repaid does the next tier start<\/em> to get repaid.
\nBy making a bunch of tiers (tranches) you can make the top ones look<\/em>
\nlike they’re really safe, even when it’s based on pile of shit.<\/p>\n

We’ve known for a long time now that tranching was a giant cheat. That top
\ntier looked safe only<\/em> because of a lie. It was only safe if the
\nchances of individual mortgages in the bundle failing to be repaid was an
\nindependent event. But the mortgages that were given out like candy to kids
\nweren’t independent in that sense: the events that caused one to fail would
\ncause almost all<\/em> of them to fail. The supposed safety of even the top
\ntranch was a bad joke.<\/p>\n

Making matters worse, the banks didn’t just sell these bundles of
\nmortgages. They layered them. They’d take a bundle of mortgages, package them
\ninto CDOs, and sell them. Other banks would buy parts of those CDOs, wrap up
\nbundles made up of slices of other CDOs, and sell those. And so on, layer upon
\nlayer.<\/p>\n

In my opinion, this was, in an ethical sense, simple fraud. Unfortunately,
\nit’s also entirely legal. It bothers me that things like this have happened and will continue to happen, take a look at the GM ignition switch Lawsuit<\/span><\/a> scandal, it would seem that fools are at the mercy of those who are meant to be the teachers. It shouldn’t<\/em> be, but most of this stuff is
\nfar beyond anything that was imagined by the people who wrote the laws.<\/p>\n

The institutions involved were effectively printing money. They were
\nissuing loans that they knew wouldn’t be repaid, but they still claim the
\ninterest from the loans as a profit. They were taking bad loans, and selling
\nthem at a profit, to someone else who claimed them as a profitable investment,
\nand who then used the non-existent expected profits from that to buy more
\nstuff – which was frequently repackaged versions of the same<\/em> stuff.
\nThe same garbage was being packaged, sold, repackaged, resold, re-re-packaged,
\nre-re-sold, and so on, over and over again, making a “profit” on each sale.
\nBut the profit was fake: bank A would make a CDO, and sell it to bank B. Bank
\nB would wrap that up with some other CDO and sell it to bank C. Bank C would
\nwrap that and sell it to bank A, which would buy it with the “profits” from
\nit’s sale to bank B. Bank B would then buy more stuff from A using the profits
\nof its sale to C. And so on. Each transaction created “profit” that didn’t
\nreally exist.<\/p>\n

Of course, it’s not quite that simple. All of the businesses involved in
\nthese shenanigans have all sorts of legal reporting requirements, and they
\nneed to have their profit statements confirmed by a supposedly independent
\nauditor. And there’s always a chance that these things would fail. In order to
\nbe able to really count them as profits, they needed some kind of insurance.
\nSo they created a kind of monstrosity called a
\ncredit default swap<\/a>. What
\nhappens in a credit default swap is that you pay someone to take your risk for
\nyou. For example, you take a loan of one million dollars that you made. You go
\nto a third party, and you pay them $100\/month. If the loan gets paid back,
\nthey get to keep the $100\/month. If the loan doesn’t get repaid, then they’re
\nsupposed to repay the entire loan principal. Effectively, it’s like a kind
\nof insurance against a loan not being repaid. With a CDO, you can supposedly
\nabsolutely count on not losing the principal behind an investment.<\/p>\n

Here’s where we get to the next two kinds of fraud.<\/p>\n

First, to sell “insurance” in the form of credit default swaps, you
\ndon’t<\/em> need to prove that you can repay the principal if the loan goes
\nbad. There are numerous cases of people with a couple of million dollars being
\nthe backers for billions<\/em> of dollars worth of credit default swaps.
\nFrom the very start, it was obvious to everyone that the CDSs were frauds: the
\npeople who were, supposedly, on the hook to repay if loans went bad had
\nabsolutely no ability to actually repay. They didn’t have the money to back
\nthe things that they were insuring, and they had no way of getting the money
\nto do it. And everyone involved knew it. Credit default swaps were, much of
\nthe time, pure fiction. Once again, though, it’s legal. The people buying
\nthe swaps simply claim that they fully expected the folks on the other side
\nto be able to pay. They never checked if that was true; they didn’t have to.
\nSo even though if anyone actually checked, it was obvious that lots of people
\ninvolved in CDSs couldn’t possibly pay up, no one actually did the checking.
\nThey just assumed that the CDS counterparties had the money to pay up if they needed
\nto. There was more profit to be made by simply trusting<\/em> the other
\nparties than by actually checking, and there was no legal requirement to check.<\/p>\n

Second, you don’t have to be the person who made the loan to buy the
\ninsurance on the loan<\/em>. Anyone can buy a credit default swap on any
\ninvestment!<\/p>\n

Just think about that for a moment. If you’re a financial trader, you can
\nbuy insurance on something that you don’t own! If we did this with normal
\ninsurance, I could buy flood insurance on a building I don’t own in New
\nOrleans. I could take out an automotive damage policy against a car that my
\nneighbor parks under a dead tree. Credit default swaps pretend<\/em> to be
\ninsurance, but they’re not. Insurance protects the owner of a property; credit
\ndefault swaps don’t do that. They’re really just simple gambling. A CDS is
\njust a bet: by buying a credit default swap, I’m betting<\/em> that the
\nunderlying loan is going to go bad. By selling a credit default swap, I’m
\nbetting that the underlying loan is good. To go back to one of my examples,
\na credit default swap is sort of like me making a bet that the car parked
\nunder a dead tree is going to get damaged. If it does, I collect. It’s not
\nmy car, but if the tree falls on it, I win. That’s a CDS. It’s nothing but
\nlegal gambling. The investment firms are bookies
\nconnecting betters on different sides, and collecting a commission.<\/p>\n

This much we’ve know for a while. This much by itself is astonishing, and
\ndisgusting, and appalling. This much is fraud on an epic scale, and should be
\nmore than enough to justify stripping the perpetrators of every dime they
\nhave, locking them into jail cells and throwing away the key.<\/p>\n

But it turns out that the reality is even worse<\/em>.<\/p>\n

How could it get worse than this?<\/p>\n

It turns out that investment firms were deliberately<\/em> putting
\ntogether packages of loans that they knew weren’t going to get
\nrepaid, in order to provide some of their customers with something
\nthat they could bet against<\/em>.<\/p>\n

Let’s go back just a bit. Remember the whole tranching deal?
\nThe investment bank puts together a shitload of mortgages, and then
\nsells shares in them. They get to take the top tranch, and sell it
\nas a high-quality safe investment. Of course, if you can’t sell
\nthe whole thing, then you’re left holding the riskiest crap. The
\nbank really doesn’t want that. So they’ll only sell a CDO if they
\ncan find suckers to buy every level of it. In order to make a CDO,
\none of the hardest things to do is find people to buy the bottom of
\nit. The worst part of a pool of mortgages is called the
\nequity, and it’s generally between one and ten percent of the
\nloan pool. You really need to work to find people willing to
\nbuy the equity tranch.<\/p>\n

But, a few years ago, at the height of the bubble, hedge funds suddenly
\nstarted volunteering<\/em> to buy the bottom tranch. They didn’t want the
\nsupposedly good stuff, they wanted the garbage. Naturally, the banks were
\nabsolutely thrilled. They put together billions upon billions of
\ndollars worth of CDOs, which were made possible by the hedge funds
\nbuying the equity.<\/p>\n

So far, nothing wrong. If someone wants to buy high-risk crap
\nin exchange for high profit, that’s their prerogative.<\/p>\n

What the hedge funds were really doing is making it possible for the
\ninvestment banks to create CDOs that were likely to fail, and then buying
\ncredit default swaps against the top<\/em> tranches of those CDOs, betting
\nthat they were going to fail.<\/p>\n

The strategy here is simple. I spend $5 million buy the bottom 5% of $100
\nmillion worth of loans that I think are going bad. I’m expecting to lose that:
\nI’m going to be out $5 million. But, I also use another $5 million to buy
\ncredit default swaps on $60 million worth of the higher tranches of that
\npool of loans. Now, if the pool goes bad, I’m out $10 million – $5 million
\nfor the crap that I bought that’s now worthless, and $5 million to
\nbuy the credit default swaps. But because the whole thing went bad, I get
\nto collect $60 million.<\/p>\n

Now we’re starting to get pretty damned sleazy. These guys want to bet
\nagainst the CDOs. That’s OK: if you believe that the things are going to fail,
\nand you’re willing to risk your money on that belief, then there’s nothing
\nwrong with you going ahead and doing it. But when you’re deliberately helping
\nto produce the things that you believe are going to fail in order to give you
\nsomething to bet against? That’s moving into the realm of at least highly
\nquestionable behavior. When you’re doing it by betting against something
\nthat you don’t even own? That’s getting worse. (Remember, these guys aren’t
\nbetting that the lowest 5% tranch that they own is going to go bad; they’re betting on the
\nhigher tranches – the upper 50 or 60%. The only reason that they bought
\nany<\/em> of the CDOs is because they things would never have been sold
\nif the banks couldn’t get a buyer for that bottom tranch.)<\/p>\n

There’s another bit of sleaze here. The credit default swaps aren’t bought
\nand sold on the open market; they’re bought and sold via private contracts. As
\nI mentioned before, most of the time, you can be the backer of a CDS even though
\nthere’s no way in hell that you could pay up if things go south. But when
\nthe hedge funds bought CDSs, they made damn sure that the people they bought
\nthe CDSs from were absolutely able to pay up.<\/p>\n

It gets worse.<\/p>\n

Anyone who honestly looked at the whole CDO thing a few years ago knew
\nperfectly well that the thing was going to collapse sooner or later. The hedge
\nfunds knew, perfectly well, that the people that they wanted to buy credit
\ndefault swaps from were likely to go belly up eventually. So they wanted
\nto be in the situation of being the first ones to collect, before the
\nbig insurers backing the CDSs ran out of money.<\/p>\n

So they didn’t just find crappy CDOs to bet against. They went to the
\ninvestment banks, and asked them create<\/em> CDOs consisting of piles of
\nspecific, high-risk loans. They provided specific requirements – complaining
\nwhen firms tried to put together better packages. They’d only back the true
\ncrap. They wanted shit that would go bad, and go bad fast<\/em>. And
\nmost of the big investment banks went along with it. (To their credit,
\na few refused.)<\/p>\n

Both the banks and the hedge funds knew what was going on here: they were
\ncreating<\/em> and then selling CDOs where they knew that the things were
\ndesigned to lose<\/em> all of the money invested in them. And the
\ninvestment banks went to their other customers, and lied! They sold these
\nthings to their customers, telling them that it was a safe, profitable
\ninvestment, even though they knew<\/em> that they were designed
\nto lose all of the money invested in them!<\/em>.<\/p>\n

The hedge funds would buy the lowest tranch of these monstrosities,
\nand then buy CDSs against the other tranches. When the loans failed,
\nthe hedge funds collected shitloads of money.<\/p>\n

The banks, meanwhile, went along with this. Why? Why would they
\nscrew over their own customers? Easy: they make money by
\nselling<\/em> the things. Sure, the people
\ninvolved had to know that, in the long term, this was likely to kill their firm.
\nBut in the short term, they were being paid cash in commissions and bonuses
\nfor selling this crap. The people who sold the designed-to-fail
\nCDOs were collecting millions and millions of dollars in bonuses. And
\nthe hedge fund folks eventually collected billions<\/em> on
\nthe swaps on failed loans.<\/p>\n

For the brokers, bankers, and hedge-fund managers, this was hugely\n<\/code><\/pre>\n
profitable. They got to take home amounts of money that most of us
\ncan’t even imagine<\/em>. Lots of them are now out of jobs – but
\nthey’ve still got their millions of dollars in the bank.  It
\nworked for them.<\/p>\n
To call this sociopathic behavior on the part of the scum involved is
\nan understatement of absolutely epic proportions. What the people
\ninvolved in this did is no different that just stealing money from the
\npeople who they suckered into buying worthless CDOs. They deliberately
\nsold worthless garbage – things that they didn’t just know<\/em>
\nwere going to lose money, but that they designed<\/em> to lose
\nmoney – lying to the buyers, telling them that it was a great safe investment,
\nknowing that the buyers were going to lose everything. But they didn’t
\ncare – because doing that would put money into their own pockets.<\/p>\n","protected":false},"excerpt":{"rendered":"
Against my better judgement, I’ve ended up writing a lot about the financial mess that we’re currently going through. If you’ve read that, you know that my opinion is that the mess amounts to a giant pile of fraud. But even having spent so much time reading and studying what was going on, the latest […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"jetpack_post_was_ever_published":false,"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":true,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_publicize_message":"","jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":false,"jetpack_social_options":{"image_generator_settings":{"template":"highway","default_image_id":0,"font":"","enabled":false},"version":2}},"categories":[71],"tags":[],"class_list":["post-852","post","type-post","status-publish","format-standard","hentry","category-bad-economics"],"jetpack_publicize_connections":[],"jetpack_featured_media_url":"","jetpack_shortlink":"https:\/\/wp.me\/p4lzZS-dK","jetpack_sharing_enabled":true,"jetpack_likes_enabled":true,"_links":{"self":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts\/852","targetHints":{"allow":["GET"]}}],"collection":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/comments?post=852"}],"version-history":[{"count":2,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts\/852\/revisions"}],"predecessor-version":[{"id":3415,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts\/852\/revisions\/3415"}],"wp:attachment":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/media?parent=852"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/categories?post=852"},{"taxonomy":"post_tag","embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/tags?post=852"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}