UPDATE: I accidentally overwrote this post with an earlier draft so this version will necessarily be different from a previous posted one. I regret the error.
Recently, as you’ve no doubt heard by now, Goldman Sachs has found itself in a bit of hot water over it’s role in the financial crisis that sparked off The Great Recession. I firmly believe that this is due to, in no small part, the story Michael Lewis tells in his book, The Big Short: Inside the Doomsday Machine. People upon hearing it are generally shocked and dismayed, including some hardcore free market Republicans.
I had the good fortune to hear a really great interview of him by NPR’s Terry Gross on her program Fresh Air. In it, Lewis lays out the basic chain of event of on how the subprime crisis started, led to financial collapse and how a few non-Wall Street professionals saw things coming months, even years in advance, by using basic investing common sense. Lewis claimed, “If everybody had thought the way they thought and behaved the way they behaved, the crisis never would’ve happened.”
The problems start with Michael Burry, Goldman and AIG and using credit default swaps to offset risk in consumer debt securities, some containing sub-prime mortgages.
But there – can I start – because there’s a slightly different answer, too, and it’s that AIG had been insuring corporate bonds for almost a decade. And in corporate bonds, there’s these pools of corporate loans. And in 2004, 2005, Goldman Sachs starts to come to AIG with pools of what they say are diversified consumer loans. They include some subprime mortgages in it and other things.
And AIG says, yeah, this is roughly the same thing as we’ve always been doing. We’ll do that, too. And it’s in March of 2005 when Goldman -there’s some conversation that is still a mystery. We don’t know exactly what happened, but Goldman Sachs effectively went to AIG with a pool of something that was nothing but subprime mortgage loans, and they said: Do you want to do this, too? And AIG said: Yup. We’ll insure that. And that, at that moment, there is a seller of insurance on subprime mortgage loans, and Goldman Sachs can turn around and peddle that to Michael Barry (sic) in the form of a credit-default swap…
And AIG had virtually unlimited appetite for this business, that they were – in a matter of a few months, they sold to Goldman Sachs $20 billion of credit-default swaps on subprime mortgages. So Goldman Sachs – very cheaply, very low prices, close to free.
And so Goldman Sachs was in the position of an intermediary, looking to lay off the other side of that. And part of what Goldman Sachs did, I think, is just take some of it on as a bet. They, too, wanted to be betting against specific subprime mortgage bonds, but part of what they did is they turned around and multiplied the price by 10 and sold them on to Michael Burry.
Lewis continues with how it all becomes what amounts to a Ponzi scheme where everyone including the Ponzi masters themselves, were taken for a ride.
The Wall Street firms, having trouble selling these triple-B-rated bonds to people, pool and find all the pieces of triple-B-rated bonds and they put them into another pool. And they go to the ratings agencies, Moody’s and Standard & Poor, and they say, say look, there are all these triple-B-rated subprime mortgage bonds but some of them are loans that are made in California and some are loans that are made in Florida and some are loans that are made in Michigan. They’re diversified. They’re not all the same thing.
Surely some of them are going to be money good. So if we put these all into one big pool and tranch it up again, how much of it will you rate triple-A? And the ratings agency says, 80 percent. They say, we think that this pool is diversified enough that, you know, if things go really bad only about 20 percent of them are going to be really seriously at risk. So, 80 percent are really safe. So you have now this called this is called a CDO, a collateralized debt obligation. And 80 percent of this is rated triple-A.
Bear in mind now, that underneath this all are subprime mortgage loans and pool of subprime mortgage loans in which only eight percent have to go bad for the whole CDO to be worth zero.
So we have Goldman and the ratings agencies facilitating what could arguably be called fraud: the selling of debt rated AAA, the safest rating possible, that should have been rated as a junk bond. A BBB California bond and a BBB Florida are still BBB. Putting them together is not diversified any more than a Hummer in New York is more diversified against gas prices than a Hummer in Texas. How could this happen?
We may never know how exactly until the trials take place, maybe not even then. I hope all is laid bare. What’s clear is that the investors who shorted these CDO’s and became very rich from their bets were vociferous about their insights and the vast majority of people, including the press, did not take them seriously. Goldman, of course, took that same bets: against assets they were selling to people as investment grade. Needless to say this was not common knowledge, though it was available if one cared to look. Goldman was respected as a premier investment bank. AIG a respected insurer. They succumbed to moral hazard for making cheap, easy money. Once they were making easy money and paying people enormous bonuses, the rest of industry jumped in with both feet. And as they say, the rest is history.