A Wall Street Invention That Let the Crisis Mutate

A Wall Street Invention That Let the Crisis Mutate

By JOE NOCERA
Published: April 16, 2010
http://www.nytimes.com/2010/04/17/business/17nocera.html?src=busln

Can it get any worse?

Every time you pick up another rock along the winding path that led to the financial crisis, something else crawls out. Subprime mortgages were sold as a way to give low-income people a chance at homeownership and the American Dream. Instead, the mortgages turned out to be an excuse for predatory lending and fraud, enriching the lenders and Wall Street at the expense of subprime borrowers, many of whom ended up in foreclosure.

The ratings agencies, which rated the complex investments that were built with subprime mortgages, turned out to be only too happy to be gamed by firms that paid their fees — slapping AAA ratings on mortgage bonds doomed to fail. Lehman Brothers turned out to be disguising the full reality of its horrid balance sheet by playing accounting games. All over Wall Street, firms pushed mortgage originators to churn out more loans that were doomed the moment they were made.

In the immediate aftermath, the conventional wisdom was that Wall Street had simply lost its head. It was terrible, to be sure, but on some level understandable: Dutch tulips, the South Sea bubble, that sort of thing.

In recent months, though, something more troubling has begun to emerge. In December, Gretchen Morgenson and Louise Story of The New York Times exposed the role that some firms, including Goldman Sachs and Deutsche Bank, played in putting together investment structures — synthetic C.D.O.’s, they were called — that were primed to blow up. They did so, reportedly, because some savvy investors wanted to go short the subprime market.

On Friday, the Securities and Exchange Commission dropped the hammer, charging Goldman Sachs with securities fraud for its purported failure to disclose that the bonds that were the basis for one particular synthetic C.D.O. had been chosen by none other than John Paulson, the billionaire hedge fund investor, who was shorting them.

Oh, and one other thing is starting to become clear: synthetic C.D.O.’s made the crisis worse than it would otherwise have been.

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Remember in the months leading up to the crisis, when the Federal Reserve chairman, Ben Bernanke, and Henry Paulson Jr., then the Treasury secretary, were assuring everyone that the “subprime problem” could be contained? In truth, if the only problem had been the actual mortgage bonds themselves, they might have been right. At the peak there were well over $1 trillion in subprime and Alt-A mortgages that were securitized on Wall Street. That’s a lot, to be sure — but it was a finite number. You could have only as much exposure as there were bonds in existence.

The introduction of synthetic C.D.O.’s changed all that. Unlike a “normal” collateralized debt obligation, which contained the bonds themselves, the synthetic version contained credit-default swaps — derivatives that “referenced” a particular group of mortgage bonds. Once synthetic C.D.O.’s became popular, Wall Street no longer needed to feed the beast with new subprime loans. It could make an infinite number of bets on the bonds that already existed.

And why did synthetic C.D.O.’s become popular? One reason was that the subprime companies were starting to run out of risky borrowers to make bad loans to — and hitting a brick wall. New Century, a big subprime originator, went bankrupt in early April 2007, for instance. Yet three weeks later, the Goldman synthetic C.D.O. deal, called Abacus 2007-ACI, went through, because it was betting on subprime mortgage bonds that already existed rather than bundling new ones. It didn’t even have to go to the trouble of repackaging old C.D.O. tranches into new C.D.O.’s, which was also a common practice. (Goldman has vehemently denied any allegations of wrongdoing, pointing out that it lost $90 million on the particular Abacus deal that is the subject of the S.E.C. complaint.)

The second reason, though, is that synthetic C.D.O.’s gave people like John Paulson a way to short the subprime market. Mr. Paulson’s bet against the subprime market, which famously reaped the firm billions in profits, was the subject of a recent book, “The Greatest Trade Ever.” Boy, I’ll say.

Both Gregory Zuckerman, the author of that book, and Michael Lewis, who wrote the current best seller “The Big Short,” make it clear that the heroes of their narratives — the handful of people who had figured out that subprime mortgages were a looming disaster — were pushing Wall Street hard to give them a way to short the market. Maybe synthetic C.D.O.’s would have been created even without their urging, but it seems a little unlikely. They were the driving forces.

It is important to note that every synthetic C.D.O. required both investors who were long and others who were short. That is, there needed to be investors who believed the “referenced” bonds would rise in value, and others who believed they would fall. Everyone, on both sides of the transaction, understood that. What makes it feel like dirty pool is the allegation that Paulson & Company and Goldman Sachs were actively involved in choosing the bonds that would be bet on — knowing they were going to be short. In its filing on Thursday, the S.E.C. charged that Goldman never told investors of Mr. Paulson’s involvement. “Credit derivative technology helped people disguise what they were doing,” said Janet Tavakoli, the president of Tavakoli Structured Finance, and an early critics of many of the structures that have now come under scrutiny.


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