CJR's Ryan Chittum is over the moon on this one:
This is a huge story. The SEC has found that its jaws still snap; Goldman, which has heretofore seemed virtually untouchable, is in the docket; it illustrates short-sellers’—John Paulson specifically here—role in creating the crisis and making billions off it; and the press and bloggers can claim a big victory, regardless of the ultimate outcome of the case. It also points the way to possible further SEC actions over the banks’ similar dealings with Magnetar, which ProPublica detailed so impressively last week.I'd like to see some pelts on the wall before I get too excited, but the idea that the S.E.C. noticed something might have gone wrong with the Abacus trades is at least encouraging.
I was thinking about Goldman's Abacus deal and the deals that Magnetar enabled and something occurred to me.
Sure, you could argue that Goldman and Magnetar had merely figured out a clever way to use the rules to maximum advantage. The standard Wall Street argument - we are predators, stop telling us to act like social workers. But you also hear a lot about moral hazard - a situation where a person is rewarded for something that causes a disproportionate amount of harm.
The last time there was a lot of play on that term - we were talking about homeowners walking away from their mortgages - or being saved by the taxpayers from their own bad choices (the Santelli argument).
Now, flip that around and look at the traditional model of investment vs. the derivitives market.
The traditional investment model, you have someone asking for money to make a product (a business that makes widgets, a bunch of home mortgages, whatever). The greater the likelihood the product will make money, the less this person will have to pay for their financing.
Well, duh - right?
The flip side of this is the investors mantra: higher returns come with increased risk.
We'd all love to have investments bringing home 10% every year (unless it's with Madoff) but most of us would be content with steady returns a little lower than that.
But think of the margin for the traditional investment model - most investments are going to bring in single digits, and have the occasional big year in the teens (if you're lucky). In exchange, you'll have some bad years and (if you adjust for inflation) you'll see a market that gets you about 3.7% return over 77 years.
Bleah.
Now take the derivative model of the credit default swap.
You'll take out a swap on a bond worth lots of money - and you'll pay a small fraction of it's value annualy. If the bond tanks, you'll get paid the full value of whatever you insured with the swap.
Since you don't have to actually own the bond you insured, you aren't being made whole for a loss you've incurred, you're just getting paid.
On a run of the mill CDO the traditional investor might get 6% - but to a company like Magnetar, betting on the CDO tanking - they could make 200% and quite possibly a lot more. The hedge fund who picked the securities for Goldman's Abacus deal got a 590% return on the year.
Now, here's the moral hazard: You're an investment banker. You have 10 billion to invest.
Do you want to scour the market for good businesses so you can get a solid 6 and the satisfaction of creating something%
Or would you rather polish turds, sell them to the ignorant and make 300%, 400% or even 500% when everything burns to the ground?
That's moral hazard.
I get that short sellers have an important role in the market, but secret short selling doesn't help the market, no do shorts where the ROI is so staggeringly out of whack that traditional investments cannot compete.
This sh!t needs to stop.
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