International Law

The End of Wall Street's Boom

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One of the viewpoints I have urged at this blog is to analyze wide departures from rationality as if the actors were engaged in systemic fraud.  The basic stance is taken from two different sciences.  

First, from the heuristic decision theory crowd, I take the general observation that there are a number of shortcuts we use to manage uncertainty.  Con criminals manipulate our use of these shortcuts, much in the way a magician manipulates our focus of attention.

Second, from the social psychology crowd, I take the general observation that social proof, liking, reciprocity, and other tricks have persuasive powers not easily dodged or evaded.   Again con criminals are acutely aware of how to trump deliberative thought.

These manipulations enable fraud, as Barry Minkow eloquently states: fraud is a sausage stuffed with lies, covered with the veneer of truth.  

Legitimate sales tricks can slide over the line into fraud, practiced by the most august and patrician among us.

Michael Lewis has written, at Portfolio, a first class description of the CDS's, credit default swap fraud, which is now racking Main Street.

Lewis writes about Steve Eisman, who had was making bets against many of the investment banks, because he believed that they had underestimated the credit risks. But listen to Eisman's strategic sense when dealing with Wall Street.

"It's not easy to stand apart from mass hysteria--to believe that most of what's in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded--without actually being insane.

A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman."Danny Moses, who became Eisman's head trader, was another who shared his perspective. Raised in Georgia, Moses, the son of a finance professor, was a bit less fatalistic than Daniel or Eisman, but he nevertheless shared a general sense that bad things can and do happen.

When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, "I appreciate this, but I just want to know one thing: How are you going to screw me?"

Heh heh heh, c'mon. We'd never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don't just happen between little hedge funds and big Wall Street firms.

I'll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade."

But the real eye-opener in all of this is Lewis' description of why for example Goldman Sachs was helping Eisman short their own products!

"Here he'd been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets.

Now he saw.

There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. The firms used Eisman's bet to synthesize more of them.

Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn't create a second Peyton Manning to inflate the league's stats.

But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs.

Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford,"

Eisman says. "They were creating them out of whole cloth.

One hundred times over! That's why the losses are so much greater than the loans.

But that's when I realized they needed us to keep the machine running. I was like, This is allowed?" 

If you short a stock, you have to borrow it from someone and pay both interest and any dividends. The company doesn't simply fake up a stock certificate, send it to you and expect a dividend stream from you for issuing a fake stock.

Now, I am only a franchise lawyer, but I am guessing that someone can make a pretty good case for fraud with facts like Lewis alleges.

Read Lewis's entire article, it is riveting stuff.

Full post as published by Misleading Advertising Law on November 11, 2008 (boomark / email).