Aristotle and Aquinas, Bank Regulators

Okay, so after years of inaction, the SEC has finally taken the offensive. True, they went after a small deal, a mere billion in “designed to fail” CDO’s on which Goldman Sachs made a paltry $15 million, an amount which, in the overall scheme of these frauds, doesn’t even amount to a rounding error, as Gretchen Morgenson pointed out. Still, it’s enough to damage the reputation of Goldman Sachs, perhaps fatally, and perhaps enough to re-establish the SEC as a regulatory force. However, there is a deep problem: what should the regulators be regulating?

We live in an age of regulation. But surprisingly, there are very few principles of regulation. As Karl Polyanyi said, “Laissez-faire was planed; planning was not.” Planning always seems to be something that always arises ad hoc, to address a particular situation, but hangs on and acquires a life (and a bureaucracy) of its own, even after the situation changes. The result is that we are simultaneously over-regulated and under-regulated; we have thousands of pages of regulations that deal with situations that don’t require any, and no regulation in areas that need to be closely watched. The regs raise formidable barriers to competition, as the small businessman often finds that the cost and trouble of dealing with them is an insurmountable barrier to entering a given business. This leaves only the large players, for whom such regulation is a mere nuisance, a cost of doing business that brings a benefit of reduced competition. And since there are fewer competitors, they tend to be more politically powerful, and proceed to capture the very regulatory bodies that are intended to curb them. The government becomes, in effect, the protector of the oligarchs rather than their regulator.

The current case is a case in point. We often hear how “complex” these schemes are, but in fact this fraud was simplicity itself. Goldman Sachs allowed a certain hedge fund trader, John Paulson, to put together a group of mortgages that would be packaged into a CDO, a “collateralized debt obligation” which was sold to Goldman’s investors. However, Paulson was also known to be shorting the mortgage market. Paulson deliberately assembled a package of loans whose underlying risk was much higher than the credit ratings indicated. Goldman Sachs then marketed Paulson’s poison-pill CDO to other banks, pension funds, and individuals. But Paulson, knowing the true risk of the security, purchased CDSs on the package. A CDS (“credit default swap”) is an insurance policy on a security that pays off when the underlying security fails. But the term “underlying security” is a fiction; Mr. Paulson did not own the CDO he was insuring. There was no “underlying security.” It is like buying a fire insurance policy on your neighbor’s house, and hoping it burns down.

Goldman Sachs didn’t bother to tell its investors that the CDO was put together by someone who was betting that it would fail. Instead, they said in their prospectus that it was put together by somebody else. Why they bothered with this lie is a bit of a mystery, since nobody ever actually reads a prospectus.

The man at Goldman responsible for selling these securities, Fabrice Tourre, knew they were about to fail. In an e-mail to a colleague, he stated,

More and more leverage in the system. The whole building is about to collapse anytime now… Only potential survivor, the fabulous Fab[rice Tourre]… standing in the middle of all these complex, highly leveraged exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

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