Investment Banking by Blood Sucking Vampire Squids

By L. Randall Wray

While investment banking today is often compared to a casino, that is not really fair. A casino is heavily regulated and while probabilities favor the house, gamblers can win abut 48% of the time. Casinos are regulated—by the state and presumably by the mob. Top executives who steal funds end up wearing very heavy shoes at the bottom of the ocean.

By contrast, the investment bank always wins, and its customers always lose. Investment banks are “self-regulated” (meaning, of course, they do whatever they want—sort of like leaving your 15 year old at home alone all summer with the admonition to “behave yourself” and keys to the liquor cabinet and the Porsche). Top management rakes off all the funds it wants with impunity. And then the CEOs go run the Treasury to bailout the investment banks should anything go wrong.

This summer I was lunching with a trader who works for one of these investment banks (hint: there are not many left, and he was not with Goldman). Speaking of Goldman he said “those guys are good”. Indeed they are so good, he said, “I don’t know why anyone would do business with them.”

He explained: When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Note that this is also true of hedge funds and the half dozen biggest banks that are bank holding companies providing a full range of financial “services”.

In the latest revelations, JPMorgan Chase suckered the Denver public school system into an exotic $750 million transaction that has gone horribly bad. In the spring of 2008, struggling with an underfunded pension system and the need to refinance some loans, it issued floating rate debt with a complicated derivative. Effectively, when rates rose, that derivative locked the school system into a high fixed rate. Morgan had put a huge “greenmail” clause into the deal—the school district is locked into a 30 year contract with a termination fee of $81 million. That, of course, is on top of the high fees Morgan had charged up-front because of the complexity of the deal.

To add insult to injury, the whole fiasco began because the pension fund was short $400 million, and subsequent losses due to bad performance of its portfolio since 2008 wiped out almost $800 million—so even with the financing arranged by Morgan the pension fund is back in the hole where it began but the school district is levered with costly debt that it cannot afford but probably cannot afford to refinance on better terms because of the termination penalties. This experience is repeated all across America—the Service Employees International Union estimates that over the past two years state and local governments have paid $28 billion in termination fees to get out of bad deals sold to them by Wall Street. (See Morgenson

Repeat that story thousands of times. Only the names of the cities and counties need to be changed. Analysts say that deals like that pushed onto Denver would never be accepted by for-profit firms. Investment banks preserve such shenanigans to screw the public. Michael Bennet, who was the head of the school district pushing for the deal had worked for the Anschutz Investment Company—so he knew what he was doing. He was rewarded for his efforts—he is now a US senator from Colorado.

Magnetar, a hedge fund, actually sought the very worst tranches of mortgage-backed securities, almost single-handedly propping up the market for toxic waste that it could put into CDOs sold on to “investors” (I use that term loosely because these were suckers to the “nth” degree). It then bought credit default insurance (from, of course, AIG) to bet on failure. By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find. In other words, the financial institution bets against households, firms, and governments—and loads the dice against them—with the bank winning when its customers fail.

In a case recently prosecuted by the SEC, Goldman created synthetic CDOs that placed bets on toxic waste MBSs. Goldman agreed to pay a fine of $550 million, without admitting guilt, although it did admit to a “mistake”. The deal was proposed by John Paulson, who approached Goldman to create toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find clients willing to buy junk CDOs. According to the SEC, Goldman let Paulson suggest particularly risky securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman’s Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—an extraordinarily high percent of CDOs that are designed to fail will fail.

Previously, Goldman helped Greece to hide its government debt, then bet against the debt—another fairly certain bet since debt ratings would likely fall if the hidden debt was discovered. Goldman took on US states as clients (including California and New Jersey and 9 other states), earning fees for placing their debts, and then encouraged other clients to bet against state debt—using its knowledge of the precariousness of state finances to market the instruments that facilitated the shorts.

To be fair, Goldman is not alone — all of this appears to be common business procedure.

There is a theory that an invisible hand will guide unfettered markets to perform the public interest. In truth, unregulated Wall Street bets against the public and operates to ensure the public loses. Investment banks are now all corporations (and all have bank charters). Corporations and banks are chartered to further the public purpose. Why do we allow them the screw the public?

13 responses to “Investment Banking by Blood Sucking Vampire Squids

  1. Hello Mr. Wray,I look forward to meeting you this year(new graduate student at UMKC). I just wanted to correct you a little on Gretchen Morgenson's story:

  2. Lol I meant Dr. Wray, not Mr. Wray..sheesh.

  3. Hi Randy, You've been on fire lately. Forgive an untutored fellow myself, but isn't an operation like this one, fraud, and aren't the individuals involved open to prosecution?

  4. Did you intend to write "By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find." 1998 ? If this is not a typo, it puts a whole new perpective on scheme plan timeline.

  5. Because if you don't proclaim your love for unfettered free markets, you are labeled a communist, socialist, Marxist, etc… Being opposed to unlimited free markets is a bigger sin than being an atheist.

  6. Question: Ever think the invisible hand is not in reference to guiding markets but rather in reference to robbing you blind? What better way to steal from someone than by using an invisible hand they will never see!

  7. Yves Smith takes a look at the NY Times article about the JP Morgan, Denver public schools deal:>>>>>I am in no position to say definitively, but Morgenson may have been spun in her report yesterday on a Denver public school financing that turned out worse than initially planned due to financial upheaval….Michael Bennett, then the school board superintendent, now a US senator, is facing a challenge in the Democratic primaries, and former school board members who are aligned with the opposition are the main (and unnamed) sources for the substantive details in this account. What is particularly [suspect] is the New York Times taking up this story now, shortly before the primaries, when this financing was covered in the Denver media over the past few years.<<<<<As part of a "correction" at the bottom of the first page of the online edition of the article, the Times concedes:>>>>>The article also failed to note that Jeannie Kaplan, a former member of the school board who was quoted as criticizing a financial transaction reached during Mr. Bennet’s tenure as school superintendent, is a fund-raiser and active supporter of Mr. Bennet’s opponent in Colorado’s Democratic primary race for the Senate.<<<<<Smith, at her blog Naked Capitalism, goes on to state:>>>>>A buddy of mine (former investment banker turned financial writer, no soft touch, and not a Colorado resident) contends the Morgenson account is off base and forwarded a message from another member of the school board from the time of the financing who lists numerous errors in the Morgenson account. I’m in no position to verify them independently, but the list is long and specific enough to be troubling. The most serious charge is that first, Morgenson got the fundamental impact of the transaction wrong, that even after allowing for its tsuris (and the extra fees involved), the deal still saved the school district money, $20 million to date. In addition, Morgenson claims the school board foolishly entered into a variable rate + swap transaction instead of a “plain vanilla bond,” thus exposing itself to more risk and unnecessary fees. The board member contends that no such “plain vanilla bond” existed for their situation, and the available fixed rate option, after allowing for fees, was more costly than the floater swapped into fixed that the board chose.<<<<<Smith then posts a point by point response to the Gretchen Morgenson article by Jill Conrad, a Denver public school board member. Early on Conrad says:>>>>>Despite the great reputation (and my own respect for the NYT), I am shocked by the lack of attention to detail and contextual information in the Morgenson article. Here is my take…and an account of at least 18 factual errors in the article…<<<<<There is some good back and forth in the comment thread for this particular Naked Capitalism post with Smith twice responding that she was "not certain where the facts lie…but Morgenson appears to have taken one side of the story."

  8. Whoops: "By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find." YES, THE DATE IS A TYPO, SORRY ABOUT THAT. 2008 I THINK (BUT LET ME CHECK IT OUT TO BE SURE).Joe: well, fraud is a legal term and will have to be settled in courts. The SEC regulates this stuff and from what I understand, they regulate the product, not the activity. If the product is "appropriate" for the buyer ("big boys" is the usual claim) then it might not be fraud. Anyway, it stinks. LRWray

  9. Eesh… I honestly don't know why anyone would do business with Goldman Sachs either. Just hearing the name makes me picture the little man in the top hat from Monopoly…But not all investment banks are created equal… I find that "job satisfaction"/"best places to work for" round ups tend to skew towards more honest, straightforward companies.

  10. Thanks for give this informative post here, I like it and will share with friends as well.

  11. This article gets to the point of a great question: What should be the role of business in the market? I see three functions: (1) Trust-busting and trust prevention, (2) Identifying and supplanting market failure, and (3) establishing light regulation for competitively functioning markets. The role of trust-busting and prevention is to not permit over-concentration in a market (the HHI test is a good measure) and create and environment of more balanced leverage between customers and providers. Failure of government to properly perform this role denies customers adequate competitive choices/remedies for dissatisfaction with their current provider/supplier. Next, the government must correctly define functioning markets – where it should be only minimally involved – and market failures – where government intervention is required. The obvious problem here in practice is that the government does not have a very good track record here as many times it interferes in healthy markets where it only serves to distort and diminish the value of the market, while other times it fails to act in areas of obvious market failure, leaving some customers (or potential customers, if the service/product is unavailable as a result of the failure) to bear the results. Examples include overregulation of historically monopoly regulated communication services despite a proliferation of competition in many areas over the last roughly fifteen years as wireline telephone companies, wireless telephone companies, cable companies, and Internet companies compete in this market. Conversely, many rural areas do not have access to high-speed Internet services – from any provider. This is a clear market failure that requires a targeted government solution to resolve.Basically, the government needs play the role of the referee and force business to behave like capitalists: Go out and earn it, provide value that customers want. This will provide an opportunity for a reasonable economic return if this value-creating activity can be performed in an efficient manner. The government cannot abdicate its role in either the area of trust-busting or supplanting areas of market failure.

  12. Investment banks are made up of departments that hand specific areas of investment. Sales and trading departments serve securities holders, investment banking departments serve governments and organizations that issue securities, and capital markets departments help mediate the securities exchange process. Thanks.