“When the tiger gets out and starts creating damage, it’s insane to blame the tiger, it’s the idiot tiger keeper” that deserves the blame.

There are the words of Warren Buffett, uttered in the defense of the Abacus deal for which Goldman Sachs has been charged by the SEC (source: WSJ). A few years ago, Buffett was an outspoken critic of derivatives, calling them ‘financial weapons of mass destruction’. Historically, he’s also been a critic of Wall Street and the way they conduct business. It now seems that Buffett has sold his soul to the devil – during the credit crisis Buffett got a large stake in Goldman Sachs and now he is doing everything he possibly can to talk up his investment. It doesn’t matter that Goldman is part of Wall Street and that it is involved in a business Buffett doesn’t understand to the core (one of his main investment mantras is to buy a simple businesses, ie Coca-Cola). In fact, Buffett has gone as far as to help block derivatives regulation in the financial regulation bill currently in the works. Additionally, Buffett’s Berkshire has over $63 billion in derivatives exposure. So much for derivatives being WMDs.*

What Buffett failed to mention, however, was the fact that Goldman Sachs and other financial institutions were in part responsible for the ‘idiot tiger keeper’. Wall Street has spent tens of millions of dollars each year to lobby lawmakers and regulatory institutions, thus making sure that the tiger keeper is as dumb as possible and as defenseless as possible so as to make sure that in the event a tiger did get loose, it would be unable to return the tiger to its cage . In fact, repealing Glass-Steagall, deciding to not regulate the derivatives markets the way futures and equity markets are regulated, increasing leverage (Commodity Futures Modernization Act, anyone?), allowing mega-mergers on Wall Street and a plethora of other stupid decisions is exactly what made the ‘tiger keeper’ and ‘idiot’.

*
“Only when the tide goes out do you discover who’s been swimming naked.” – Warren Buffett

“Only when the crisis hits do you discover who’s been a self-serving hypocrite.” – Reworded to describe Warren Buffett

SEC goes after Goldman from Marketplace on Vimeo.

Chairman of the CFTC, Gary Gensler has really grabbed the bull by its horns – he is proposing wide-ranging reform of the over the counter derivatives market, with a special focus on credit default swaps. I understand that for some of you this might look like gibberish, but it is important to understand that derivatives played an important role in the credit crisis (see this link for explanation). Without credit default swaps, AIG wouldn’t have needed a bailout. Lehman would not have failed, were it not for their huge (off-balance sheet) position in mortgage derivatives such as CDOs and synthetic CDSs.

Here are some excerpts from Mr. Gensler’s speech, the full version of which can be downloaded here: Keynote Address of Chairman Gary Gensler, OTC Derivatives Reform, Markit’s Outlook for OTC Derivatives Markets Conference. All highlights are my own.

The 2008 financial crisis had many chapters, but credit default swaps played a lead role throughout the story. They were at the core of the $180 billion bailout of AIG. The reliance on CDS, enabled by the Basel II capital accords, allowed many banks to lower regulatory capital requirements to what proved to be dangerously low levels. They also contributed to weak underwriting standards, particularly for asset securitizations, when investors and Wall Street allowed CDS to stand in for prudent credit analysis.

Mr. Gensler goes on to talk about reform:

Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Here, Mr. Gensler makes an excellent point regarding the right to buy insurance. It is not known to many that credit default swaps can be bough ‘naked’, that is, you can buy insurance on an institution that you don’t even have stake in. That would be like buying fire insurance on your neighbor’s house -  it doesn’t take a college degree to figure out what happens next to the house in question. Mr. Gensler:

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

Hat tip: Barry Ritholtz
Image courtesy Businessweek.

From Bloomberg:

The U.S. House is considering reinstituting the Depression-era Glass-Steagall Act, which barred bank holding companies from owning other financial companies, Majority Leader Steny Hoyer said today.  A renewal of the 1933 law “is certainly under discussion” by House members, Hoyer, a Maryland Democrat, told reporters in Washington. The Glass-Steagall law was repealed in 1999 to help pave the way for the formation of Citigroup Inc. by the $46 billion merger of Citicorp and Travelers Group Inc.

Glass-Steagall was the law that kept commercial banks (the likes of Bank of America before its purchase of Merrill) and investment banking separate. It was intended to stabilize the banking system and is served its purpose for over 60 years until 1999, when it was repealed by the Gramm-Leach-Bliley Act. The latter is what got many banks into trouble in the current financial crisis. When the Glass-Steagall Act was first instated, it was done to stabilize the banking system that had failed after the crash of 1929. It was only the Great Depression that got politicians thinking. Out of it, the SEC was born. But the formation of SEC came with a lot of new regulations, regulations that investors and traders these days consider to be vital. Mandatory reporting is one of them – before the financial reform of the 30s, companies didn’t have the obligation to report quarterly or even yearly transactions. There was no obligation to disclose insider ownership or even the number of outstanding shares, for that matter. Glass-Steagall was one of the cornerstones of these reforms and the US has to reinstate it, for the sake of its trustworthiness, but also for the sake of the banking system as a whole.

Phil Gramm, the former Republican Senator from Texas who co-wrote the act that undid Glass-Steagall:

I’ve never seen any evidence to substantiate any claim that this current financial crisis had anything to do with Gramm-Leach-Bliley. In fact, you couldn’t have had the assisted takeovers you had. More institutions would have failed.

Really? REALLY??!! Stealing from the American public is now called God’s work? These guys can’t be serious. But that was not all. This outrageous claim was later followed by another statement:

“We participated in things that were clearly wrong and have reason to regret,” Blankfein, 55, said at a conference in New York hosted by the Directorship magazine. “We apologize.”(source)

What exactly did you have in mind when you said that you “participated in things that were clearly wrong”? Would you care to specify? What about stealing billions of dollars from the American public via your accomplices at the Treasury Department and the New York Fed? This is clearly not a ‘mistake’, this is fraud and should be prosecuted as such. And where is the SEC and the DOJ? Why aren’t they doing anything about it? Recent media reports have been pretty clear about the fraud involved in the bailout of AIG, of which Goldman was a beneficiary to the tune of $12.9 billion (sic!). Last but not least, this ‘apology’ was not accompanied by a promise not to repeat these ‘mistakes’ again.

This statement was accompanied by a promise to give small businesses $500 million dollars in loans to help them recover from the recession. Of course, they left out the part where it says that it’s actually government money that they’re ever so willingly loaning out:

“Goldman Sachs repaid the $10 billion it was given last year under the taxpayer-funded Troubled Asset Relief Program, plus dividends. The firm continues to benefit from federal guarantees on about $21 billion of long-term debt.“(source)