The Math is NEVER, EVER wrong!

The Wall Street Journal has put forward an article that adds color to the general view I have always held about securitization, risk-shedding, and what I allege amounts to organized, systemic fraud by our "big banks."
While they focused on Goldman Sachs, it is a serious error to maintain focus there as a "universal" or "sole" villain.  Quite to the contrary - the entire financial system became one gigantic fraud machine during the last 20 and especially the last 10 years.
Nonetheless, let's walk through and identify the scams that were built into this model:

Goldman Sachs Group Inc. played a bigger role than has been publicly disclosed in fueling the mortgage bets that nearly felled American International Group Inc.

Of course.

In Goldman's biggest deal, it acted as a middleman between AIG and banks, taking on the risk of as much as $14 billion of mortgage-related investments. Then Goldman insured that risk with one trading partner—AIG, according to the Journal's analysis and people familiar with the trades.

This sounds ok, right?  You take on a risk, then you insure against something going wrong.  This is how one does business.  Except....

The banks wanted protection in case the housing market tanked. Many turned to Goldman, which effectively insured the securities against losses. Then, to cover its own potential losses, Goldman bought protection from AIG, in the form of credit-default swaps.
Goldman charged more than AIG for the protection, so it was able to pocket the difference, making millions while moving the default risks to AIG, according to people familiar with the trades.

Here's the definition of the problem: Exactly how did AIG price the protection at less than Goldman?

One of them was wrong in their assessment of the risk. 

But that's ok - people take on risk all the time, and at times they guess wrong.  This is what makes a market, and if things ended here it would all be ok.

But it didn't end here.

A Goldman spokesman said that between mid-2007 and early 2008, Goldman showed AIG "market price levels" at which trades could be undone, allowing AIG to decrease its risk, but "AIG refused to accept that the market was deteriorating."
When Goldman didn't get as much collateral as it wanted from AIG, in 2007 and 2008 it bought protection against a default of AIG itself from other banks.

But wait a second - I thought AIG had prudently underwrote those original CDS?  No?

What has Goldman said about this?  Well.....

"What is lost in the discussion is that AIG assumed billions of dollars in risk it was unable to manage," the Goldman spokesman added.

Really?  But Goldman was willing to buy that protection from a firm that was unable to manage their risk.

This goes back to what I have said since The Market Ticker began:

If I make a loan to you that has a risk-adjusted return of 300 basis points (that is, 3%) over Treasuries of the same maturity, that is all the return that is available in the transaction.

Each and every person who handles that transaction demands some amount of money to do so, as nobody works for free.

The only way to obtain more than 300 basis points of return from that transaction is to find someone who will enter into a trade that they cannot cover - that is, someone who will go broke and be unable to pay off in the adverse circumstance.

This is the fundamental scam in finance that has infested the banks and other institutions over the last 20 years - and which accelerated in the 2000s.  The entire game rested on the premise of finding someone who would write insurance they could never pay on, or who would utter an "opinion" that the deal had less risk in it than it really did.  In point of fact virtually all of the lending risk for all non-standard mortgage instruments written from 2003-2007 was predicated on one and only one thing - property values would never go down. 

Why?  Because none of those loans, analyzed dispassionately on the standard "5Cs of credit", were likely to perform to maturity.  None of them.

This scam is in fact exactly what Paul Volcker was talking about in the piece quoted on the 9th:

“I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence,” said Mr Volcker, who ran the Fed from 1979 to 1987 and is now chairman of President Obama’s Economic Recovery Advisory Board.
He said that financial services in the United States had increased its share of value added from 2 per cent to 6.5 per cent, but he asked: “Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”

Right.

Effectively, what the financial system has done is siphon off an increasing portion of the rents charged for various activities while justifying the increasing prices (that is, lower risk and therefore less reserve against "adverse events") through concealment via bogus "risk-shifting" and "risk-management" that in fact never really occurred.

Remember, "rent" is a generic term.  We think of it as what you pay to occupy an apartment, but in fact "rent" is charged for the use of capital in all of its forms - as a place to live, as a means of financing investment, as a means of financing speculation.  All involve the charging of rent of one form or another, and all the financial system has done over the last 20 years is find ways to increase the amount of rent that lands in the financial system itself - instead of being distributed to the actual owners of the capital that is being lent out!

The simple reality is that CDOs, CDS and similar articles when used to hedge large quantities of financial instruments or events (such as by a bank) are an artifice.  The only way that one can "deal in" CDS and make a profit, as the banks have done, is if someone is willing to sell you protection at less than the true risk-adjusted cost, or you can manage to sell it at higher than the risk-adjusted price.

Both require that someone be deceived - that is, that someone intentionally misrepresent either by commission or by intentional concealment of material facts.

This is the definition of fraud!

Fraud is generally defined in the law as an intentional misrepresentation of material existing fact made by one person to another with knowledge of its falsity and for the purpose of inducing the other person to act, and upon which the other person relies with resulting injury or damage. Fraud may also be made by an omission or purposeful failure to state material facts, which nondisclosure makes other statements misleading.

It is not possible for you to buy protection for less than the actual risk of default from a party who can pay in the event of default.  This should be instantly obvious to anyone who applies more than 15 seconds of thought to the problem - on balance it is impossible to insure a pool of risks for less money than the risk of loss across the pool.

Let's assume the risk of default is 1% and recovery if there is a default is 50.  Therefore, if you have $100 million of such bonds 1% of them, or $1 million worth, will default, and of that $1 million there will be a $500,000 loss.

The price of purchasing insurance against that pool must always be more than $500,000.

If it is less then the company writing it will not be able to pay.  If it is in fact equal they will not be able to pay, since the company must expend some amount of money (no matter how small) employing their staff and maintaining their facilities (buildings, etc.)

It is reasonable for someone to buy insurance against a single event, as a single actor, holding a single risk.  That's because their individual risk is large for the return they receive.  It is why you buy insurance against a fire in your house - the risk of a fire is small, but the damage if you suffer a fire is large.

But if you own 100,000 properties dispersed across the nation with no particular concentration you're an idiot to buy insurance against each and every property having a fire.  Why?  Because it is axiomatic that you will pay more for the insurance than you will lose to fires!  You must - otherwise the insurance company that sells you the policies will go broke and be unable to pay at all! 

The key point here is that when you buy below risk-adjusted cost "insurance" you have in fact bought nothing and are just as exposed as if you had not purchased said "insurance" at all.

It is therefore never prudent and appropriate for anyone who holds a large enough pool of risk to "transfer" that risk to a third party because the cost of doing so will always be higher than the cost of simply absorbing any losses that occur. 

This must always be the case unless the organization holding the large pool of risks is able to find someone who will write that insurance at a loss.  This, in turn can only happen if the entity writing the insurance either (1) is unable to appropriately judge the risk compared to the person purchasing the insurance or (2) is unable to pay if the loss occurs.

This is the root of the scam folks, and that we refuse to understand and face the math is part and parcel of why it is that we continue to be abused by these large financial interests.

The sooner we wake up the better, as the math is never, ever wrong.