Two weeks ago, On The Media (my very favorite NPR show, which is saying something as it has stiff competition) interviewed NPR economics correspondent Adam Davidson about the challenges of reporting on financial reform. Davidson is part of the Planet Money team, which produced the amazing, indispensible “Giant Pool of Money” episode for This American Life (the major competitior for my NPR affections) which explained causes of the housing and financial crisis in terms non-experts can understand. He’s a very smart guy with a great track record of explaining tough financial stories. And he thinks that financial reform might be beyond what financial journalists can explain to their audiences:
We have used songs. We’ve used theater sketches. We’ve interviewed over a hundred economists, trying to find the ones who can just really nail an explanation in a clear, concise way. And, honestly, like we’ve picked off pieces, we’ve told little elements of it, but the big “here is what regulation is all about and we’re going to tell you how it works” we have not been able to crack.
I feel like I have seen the edge of what journalism can accomplish, of what journalism is capable of, and the bulk of financial regulatory reform is on the other side of that edge.
It’s possible that the combination of a brilliant piece of financial reporting and an important breaking story might pull Davidson back from the edge.
The breaking story is the SEC’s decision to charge Goldman Sachs with defrauding investors in failing to disclose the influence a hedge fund had in assembling a collateralized debt obligation. (Eyes glazed over yet? Now you understand Davidson’s problem.) But before you try to unpack that story, allow me to recommend another one.
Jesse Eisinger and Jake Bernstein of ProPublica put together a fascinating story called “The Magnetar Trade” about the role of a savvy – and likely unethical – hedge fund manager in inflating and profiting from the real estate bubble. The story’s available on ProPublica’s website, and it’s been turned into a surprisingly compelling radio story – “Eat My Shorts” – by This American Life’s Alex Blumberg.
Here’s the heart of the story:
A hedge fund called Magnetar made a set of very strange investments in 2006 and 2007. They bought into collaterized debt obligations, pools of mortgage-backed bonds. They bought the riskiest pieces of these investments – the equity tranche – for quite small amounts of money. But their willingness to take the riskiest pieces of these investments made it far easier for investment banks to sell the rest of these CDOs for very large sums of money. So far this is just an odd, high-risk strategy – if these CDOs suceeded, Magnetar would get high returns on what had been very modest investments… but the bottom was starting to fall out of the housing market in 2006, and it seemed more likely that these CDOs would default.
Magnetar did something very clever and, in my opinion, somewhat unethical. They bought credit default swaps – insurance, essentially – on these CDOs. The insurance isn’t all that expensive to buy, and it pays the face value of the asset if the asset proves to be worthless. But Magnetar didn’t “insure” the equity tranche positions they took – they bought insurance on the much more expensive, investment grade tranches of the CDOs. In effect, they found a way to convince people to build mansions in a dangerous neighborhood by building a shack there, then took out fire insurance on those very expensive homes, which they didn’t own.
To make sure the fire started – i.e., the CDOs collapsed, making the equity tranche worthless, but allowing the credit default swaps to pay off – Magnetar allegedly pressured the bankers who assembled these CDOs to include very risky assets in them (bonds made up of bad mortgages.) This is something you’d never do if you wanted the CDOs to succeed… and it’s precisely what you’d do if you’d bet on them failing. In other words, Magnetar didn’t just buy fire insurance on someone else’s mansion – they filled their shack with oily rags, knowing it would increase the chance of the neighborhood catching fire. (In my opinion, we’re now deep into the realm of unethical behavior, but that’s my opinion… and may not be regulators’ opinions.)
Magnetar made enormous amounts of money. Investment banks who build the CDOs made lots in fees for putting together the deals… though they lost lots investing in their own bad deals. And pension funds and other large institutional investors often lost their shirts on CDOs that had been packed with toxic crap by Magnetar, which was betting against those very investments. Those losses affect real people – people with state pensions – and the investment bank losses are now being paid for by taxpayer bailouts.
The amazing thing – it’s not clear that Magnetar broke any laws. They were allowed to hedge their CDO positions with credit default swaps… even if the hedge position wasn’t an exact hedge. (Remember, they didn’t ensure the crap they’d bought at the low end of a CDO – they bought insurance on the good stuff at the top of a CDO.) Eisinger and Bernstein suggest that what investment banks did, on the other hand, was questionable both in terms of ethics and securities law. They built new securities – CDOs – knowing that a hedge fund had pressured them to make these securities more risky… and that the hedge fund was making a bet that these securities would fail. They then sold the top tranches of these securities as triple-A investments to credulous investors.
And that’s what the SEC is charging Goldman Sachs with. The charges aren’t in relation to trades made by Magnetar, but by Paulson & Co., but the idea’s the same. The SEC alleges that Paulson told Goldman to build crappy CDOs, sell them to credulous investors while knowing that Paulson was betting against the success of the CDOs using credit default swaps. Needless to say, Goldman denies this – and if it’s demonstrated that they did in fact do it, they’ll allege that it was the action of a single bad VP, Fabrice Tourre – just as Magnetar denies doing anything untoward.
So here’s my question: does this change the landscape around financial reform? Magnetar and Goldman/Paulson demonstrate that unregulated derivatives like CDOs and CDSs can be “financial weapons of mass destruction“, particularly when wielded by banks that are apparently willing to screw over one group of investors to benefit another client, a hedge fund.
How the @#*%^$! can the GOP and the financial industry argue against strengthened financial regulation? President Obama has said that he won’t sign legislation that doesn’t strengthen the rules around derivatives like CDSs. That sure sounds like a good idea, when regulators can’t currently agree whether screwing over investors as Goldman is accused of is actually illegal.
The answer, of course – the argument won’t be about this complex story – it will be about a straw man, the assertion that financial regulation will consist of a policy of government bailouts extending from here to the horizon. And if folks like Adam Davidson and colleagues can’t explain these stories in language people understand, the narrative that Obama wants to bail out the banks may well be more compelling than the complex story of hedged bets and short trades.
In the meantime, everyone’s searching for metaphors. Mark Gimein, writing in Slate, explains the Goldman/Paulson deal in terms of a used car lot filled with hand-picked lemons. The ProPublica site uses a tower of champagne classes to explain the different tranches of CDOs. You’ve read my lame arson shack metaphor. Thankfully, the This American Life folks are professionals. They’ve explained it in terms of a Broadway showtune:
It may be as incomprehensible as anything written in any of the excellent stories referenced here… but damn, it’s funny and something of an earworm.