From One Pigman To Another….
Courtesy of Karl Denninger at The Market Ticker
It seems fitting that Berkshire’s Buffett would support Goldman’s Lloyd "100%":
“He’s done a great job running that firm,” Buffett said today in Omaha, Nebraska in a Bloomberg Television interview before the shareholders meeting for his Berkshire Hathaway Inc. “He’s smart. He’s high grade.”
Let’s remember that Buffett’s Berkshire is short size in the S&P on a "custom derivative contract" that he cannot walk away from (nor can they be exercised early against him.)
Mr. Buffett, who invested $5 billion in Goldman at the height of the financial crisis, said he didn’t believe that Goldman had acted improperly. Rather, counterparties to the deals, which plunged in value when the housing market fell apart in 2007, should be responsible for their own actions.
Mr. Buffett said he believed that one of the banks that had purchased Abacus deals in the transaction, the Dutch bank ABN Amro Group, was a sophisticated investor. "It’s a little hard for me to get terribly sympathetic for a bank that made a bad credit deal," said Mr. Buffett.
The "sophistication" of the investor is irrelevant to a Rule 10b(5) case, as are all of the other complex elements of common fraud cases. Indeed, whether the misled party had reason to believe it was being lied to, had the opportunity to do diligence and failed and other things you must prove in a common fraud case do not apply here.
All the SEC needs to be able to prove is that either an intentional omission or a false statement was made that, had it not be omitted or made, would have led the investor to not make the investment they did in fact make.
That is, Rule 10b(5) sets forth a simple standard with little or no "wiggle room."
Warren went on to say:
He said a firm that had acted as an intermediary in the deal, ACA Management, had drifted from its original business of insuring municipal bonds into structured finance, a more complicated and risky business. He said he believes most press accounts haven’t properly explained ACA’s business model.
Does that include the alleged interlocking of high-level officials in both Goldman and ACA?
Of course he supports "The Bezzle"; when financial firms are expected to be 19% of S&P profits by the end of this year (up from 12% estimated for the first quarter) anything that impacts those earnings could lead to Berkshire having a wee problem with the mark-to-market on those PUTs.
Ripping people off is and has been such a fantastic business, you know. Then there’s this:
Buffett said he will discuss the trade at the center of the regulator’s suit later today at the meeting and “I will bet that of the 40,000 people in there, 39,900 of them have a misconception.”
Yeah well I don’t own any of your stock so I won’t be there. Never mind that I wouldn’t countenance the price-gouging that the airlines have engaged in this week for flights to and from that area either – fares more than double their usual going rate.
The latter, of course, is capitalism. In point of fact I have no quarrel with it – I just refuse to pay. No willing buyer here.
Clients who make trades with Goldman Sachs don’t rely on the bank for its opinions, Blankfein told Levin. “The thing we are selling to them is supposed to give them the risk they want,” Blankfein said.
There’s nothing wrong with selling someone "the risk they want."
Making loans to someone who can’t pay on the original terms is, however, wrong. This was the genesis of the crisis. It’s also been a common tool of finance for the last twenty or even more years, especially in the commercial real estate environment.
Loans that are effectively "interest only balloons" are imprudent in each and every case where there is no real skin in the game – that is, where the current collateral value pledged as security approaches or is the same as the principal on a loan that does not amortize. Such a loan requires that the collateral value be stable or increase through the entire term, or the loan becomes "underwater" and thus extremely dangerous for the writer. 2/28 and 3/27 home loans, nearly all commercial real estate loans, Option ARMs and I/O loans all fall into this category when the combined loan-to-value ratio exceeds 80% at any time during the loan’s term, as such a loan is effectively "naked" due to the foreclosure, remarketing and time value of money costs involved in securing performance if there is a default.
These loans are never "investment grade" and no amount of slicing, dicing and alleged "pooling of risk" will make them so. Recessions and other business disruptions are often national or even global phenomena, and as a consequence there is no means available to pool risk and resolve that problem. Securitization will allow some investors to have an investment-grade bond out of these things but the average risk across the entire pool is in fact increased by such machinations, because securitization costs money and that money must come from the cash flows on the underlying instruments.
That is, if the "real" risk is that 1 in 5 of these loans will ultimately default and when they do recovery will, on average, be 50%, then ten percent of the pool will be lost. If half the pool holders (through securitization) take zero loss then the remaining half must take a 20% loss. This is math and no amount of "engineering" changes it.
So-called "financial innovation" is, in the main, an attempt to declare that 2 + 2 = 5. This is inherently an artifice to which the underlying mathematical realities cannot yield, as 2 + 2 is in fact 4.
Let’s remember too that Buffett objects to one of the clauses in the derivatives legislation currently on The Hill – that is, the requirement that all swaps that are underwater have cash (or equivalent) margin posted against them.
He argues that Berkshire should not have to do this because the original contract was written with "trust me" (that I’m solvent and able to pay) written in it, and that "sanctity of contract" controls.
No, Warren, it does not.
There is no contract at all if you promise to do something you’re physically incapable of. You and I cannot contract for me to jump over the Empire State Building, because I am physically incapable of performance. Irrespective of what the claimed agreement says about penalties if I breach such an agreement, you will not be able to collect in a lawsuit, because in order for a contract to be valid we must not have entered into an agreement to do the impossible.
The problem with Berkshire’s argument in this case is that under ordinary conditions everyone can perform. It is only under extraordinary conditions that performance doesn’t happen.
But the buyer of the protection purchased it precisely to protect against an extraordinary set of circumstances!
In other words, performance under the most-adverse possible scenario was the primary concern of the person on the other side of the transaction. That is always the case in any "insurance-like" transaction – whether the risk being the catastrophe of a tornado, hurricane, flood, or – as in this case – financial meltdown.
The posting of collateral, of course, proves you can perform – especially if that posting is required daily, and as a position goes against you margin requirements increase by the amount you are underwater.
But this is exactly what the regulated derivatives markets require on a daily basis and they should!
That is, I can be "Short" the S&P 500, oil, or other regulated instruments all I want, but if the price rises the amount of money I have to have on deposit with my broker to guarantee that I can perform my end of the bargain goes up commensurately – and that amount is computed in real time. I can also be "Long" these derivatives and if my position goes against me due to falls in the market I am likewise required to continue to post more and more margin to prove I can perform.
Why should anyone be able to create or maintain an instrument where this is not the case?
The entire reason we have (and had) a "systemic risk" problem is because institutions did not (and still do not!) have to post that collateral. That is, they were not required to prove on a daily basis that their positions were money good or have them liquidated out from under them by force.
This in turn allowed (and allows) people to lie about the risk in the instruments they both write and hold.
A credit-default swap (protection against a default), for example, can never cost less than the actual risk of loss, if the intent is to actually provide that protection. That is, such a product is inherently a negative sum game; the person writing the swap must make a profit to remain in business, and they must also price that swap at or above the actual level of risk in order to be able to pay (that is, remain in business!)
So long as all derivative contracts require the nightly maintenance of margin against underwater positions there is no systemic risk. The reason for this is simple – as positions go underwater the person on the "wrong" side is forced to pony up money to prove that they can perform their obligations to the other party. When that underwater party runs out of money their positions are liquidated.
This event might cause the firm involved to go bankrupt but since their positions were covered up to that point with actual money there is no "cascade of failures" that can occur – their counterparties in each and every case are made whole at that instant, in that their derivatives are "cashed" right then and there at the marked value as of that point, with the counterparty getting the money owed.
That event might cause additional stress in the system, but again, so long as the remaining parties that are trading have to continue to post their margin for underwater positions the entity on the other side is and should be fully secure. The forcible unwind of these positions may cause further price deteriorations to occur, but again, this is not the realization of "systemic risk"; that is, a disorderly collapse where counterparties do not get paid.
The financial system, unfortunately, has become rife with fraud, and it all centers around these contracts where no cash margin requirements are enforced. If I can write "protection" or "swaps" where I do not have to maintain cash margin against every penny of underwater exposure on a nightly basis then any event that exposes my deficiency in ability to pay causes an instantaneous set of cross-defaults. That is, since I cannot pay the person on the other side of the transaction suddenly suffers a monstrous loss, which is likely to cause them to be unable to pay on their obligations.
There is only one way to prevent this from happening, and that is to force all financial products to be settled via an exchange, where the exchange is in fact the buyer for every seller and the seller for every buyer. The exchange must be mandated by law to collect and hold cash or cash-equivalent collateral in segregated escrow for each party executing trades through it sufficient to guarantee performance for each and every product that is open.
We do this today for listed options and futures contracts, and it works. Firms and individual traders go out of business all the time as a consequence of margin calls, yet this does not "hurt" the party on the other side of the transaction – indeed, that party doesn’t even know who their counterparty is because an exchange effectively "double-blinds" the transaction. This both protects the market from manipulation for or against any single firm or participant and guarantees that the transactions entered into will clear.
If we do that and prosecute everyone who sells something that they’re misrepresenting by either omission or commission (under already-existing Rule 10b5) then most of The Bezzle goes away.
But so does the ability of people like Buffett (in his financial businesses) and others (in theirs) to skim off outsize amounts of money from the economy.
Is it any wonder he "opposes" that?
Pigman photo by hueydumps, Photobucket
