The US Market’s Pyramid of Lies

Sack Henry Paulson. Liquidate Goldman Sachs. Call Alan Greenspan to account. End Moody’s rating franchise. Arrest a few dozen salesmen of Collateralized Debt Obligations (CDOs). Those should be the correct responses to the chaos roiling western financial markets and beginning to have a knock-on effect on an otherwise soundly placed East Asia.

The market chaos is not a random event like a tsunami. This is the direct consequence of the Ponzi schemes created by Wall Street to satisfy its own inestimable greed. It is the result of a pyramid of lies which has immeasurably enriched US Treasury Secretary Paulson (whose shares in Goldman were worth almost US$1 billion) and a whole class of similar investment bankers at the expense of millions of US home owners and tens of millions of pension plan investors around the world who were persuaded to buy Wall Street’s elegantly packaged deceptions.

The king of Wall Street for the past several years has been Goldman Sachs and the king of Goldman was, until last year, Paulson. He was paid US$29 million and his successor Lloyd Blankfein, who took over in mid-year, was paid $53 million. They should give all that back, not to the shareholders of Goldman but to a fund to help its myriad victims.

Goldman was just one of several bulge-bracket banks to make billions from the concurrent booms in CDOs, mortgage writing, private equity expansion, leveraged buyouts, etc. The first to hit a wall was, probably by chance, Bear Stearns. But it could equally well have been Merrill Lynch, JPMorgan Chase or a similar “master of the universe” from a Wall Street which has long been determined not to learn anything from that moral tale of the late 1980s, “Bonfire of the Vanities” but to emulate the “greed is good” philosophy of Gordon Gecko, the cinematic icon of the era.

The instruments that Wall Street created were in many ways highly sophisticated. But at bottom they were just versions of the Ponzi scheme by which investors are attracted on the basis of past profit performance which has been rigged, deliberately or not.

There have been several stages to the creation of this pyramid of debt and deception and Wall Street has been at the heart of all of them.

First was the sub-prime mortgage lending which may have begun as an honest attempt to help low-income earners buy their own homes at a time when interest rates were (thanks to former Federal Reserve Chairman Alan Greenspan) abnormally low for abnormally long. But it soon became an all-out campaign to offer mortgages to anyone as expansion of balance sheets was the way for loan officers to make fat bonuses. “No money down” offers to finance 100 percent of the house value became common.

On top of that, borrowers were attracted by absurdly low teaser rates which escalated rapidly after two or three years. In many cases proof of earnings was not required and websites offering bogus income and credit histories flourished openly. It is impossible to believe that Wall Street did not know what was going on. But greed rules. The name of the game is balance sheet expansion. Look at Goldman itself – after several years of exceptionally rapid growth total assets rose another 18% in the 9 months to May this year, an annual rate of 24%.

The next stage – and this is where Wall Street particularly excelled – was to package these loans into different instruments, the first stage being simple bonds secured on groups of mortgages and the next the creation of CDOs which assembled different kinds of debt obligations, slicing and dicing them into components to be sold to pension funds, banks, insurance companies, and hedge funds.

The next element was to use the likes of Moody’s, the ratings agency, to accept some statistical alchemy and thereby raise the credit rating of the instruments above that of the underlying loans. Thus a package of sub-prime loans could be washed and ironed, emerging as class A credit.

Of course, the buyers were often also in cahoots with the sellers, which probably explains why big European banks such as France’s BNP Paribas and Germany’s IKB were among those to stuff these assets into their managed funds. Other big buyers and losers included the likes of Harvard’s endowment fund just the sort of fund to be run by too-clever-by half Wall Streeters. They all liked the extra yield this stuff provided and chose to ignore the dubious basis on which A credit ratings were obtained or the fact that these instruments were not traded and so could not be marked to market. They were worth what the issuers said they were worth – until they tried to sell them.

The sheer scale of these ponzi activities is indicated by the fact that in the first quarter of this year alone US$251 billion worth of CDOs were issued and including US$121 billion of credit default swaps – instruments by which banks sell risk to each other.

The totally opaque nature of this business has long been a scandal which dwarfs the kind of lending scandals that preceded the Asian crisis of 1997. It bears some resemblances to Japan in the late 1980s, though that turmoil was largely confined to Japan.

What happens next is anyone’s guess. Already the European Central Bank has had to provide tens of billions in liquidity to European banks because markets have simply frozen. Why have they frozen? Because no one trusts each other, no one trusts the value of the securities they hold or want to sell.

That the European Central Bank, which has been less prone than the Fed to mollycoddle investment bankers or succumb to political pressure for low interest rates, has had to launch a rescue on this scale is an appalling reflection on the western financial system.

Will the Fed’s Ben Bernanke tough it out, following in the footsteps of Paul Volcker in the early 1980s and refuse to bail out Wall Street? Or will Paulson persuade him to come to the rescue of his greedy and dissembling buddies, as Greenspan did when he rescued Long Term Credit Management in 1998? Is crony capitalism as alive in the US as it was in Asia before the crisis?

If it is the latter, sell every greenback you own – and then some.