You Buy, I Short

A recent New York Times article, entitled, “Banks Bundled Bad Debt, Bet Against It, and Won,” poses a serious policy challenge for Washington.  The article describes how many top investment banks like Goldman Sachs, Morgan Stanley and Deutsche Bank created a plethora of mortgage-backed assets, like collateralized-debt obligations (C.D.Os) and credit-default swaps, aggressively marketed these securities to their investors, while themselves selling those same securities short.  Initially, these C.D.Os were created by investment banks to hedge against losses if the housing market crashed.  However, executives at Goldman Sachs and other investment banks realized that they could reap huge profits by creating more of such securities and betting against them.  

In particular, the article tells the story of Abacus.  Goldman Sachs started making Abacus deals in 2008, and by 2008 they had made 25 Abacus deals worth a total of $10.9 billion.  Abacus allowed investors to bet for against the mortgage securities linked to the deal.  In actuality, the C.D.O’s didn’t contain actual mortgages; rather they included credit-default swaps, a kind of insurance that pays when a borrower defaults.  The creation of credit-default swaps allowed investment banks to make large bets on mortgage defaults.

Instead of allowing their customers to sell Abacus short, Goldman Sachs kept most of those wagers to themselves.  Moreover, the investment bank tried to make Abacus look better than it actually was.  They even tried to convince Moody’s, a credit rating agency, to increase the rating of a part of an Abacus C.D.O.  In 2008, when the mortgage market plummeted, Goldman Sachs and other investment banks made a killing.

While there is nothing wrong in creating C.D.O’s or credit-default swaps, or in betting against them, there is  something immoral with persuading others to buy them while selling them short yourself.  According to Sylvain R. Raynes, an expert in structured finance at R&R Consulting, “The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen.”

Since these securities were not traded publicly, misinformation abounded.  This issue further emphasizes that any financial regulatory reform requires the creation of exchanges where these securities can be traded.