Designed to Fail
A new phrase has made its way into financial news stories: “‘designed to fail’ investments.” Once again, Goldman Sachs is being implicated in financial impropriety. This latest twist is part of the same old story: someone was tricked into buying a bad product by someone who was gaming the system. As Will Hutton says, "the financial meltdown wasn't a mistake --- it was a con."
For well over a year we’ve known that Goldman (and all the other large investment firms) have marketed mortgage-backed securities while also betting that those same securities would plunge in value. This reckless, and I’d say fraudulent, behavior was not illegal. Now, we’ve learned that Goldman has marketed ‘designed to fail’ investments on behalf of a hedge fund client. Goldman allowed this client to hand-pick the worst, most risky mortgages to include in a special set of mortgage-backed securities. Goldman marketed these securities to unsuspecting investors who weren’t in on the game. Meanwhile, the original client, who did not buy any of the securities, bet that they would fail. When the bonds did fail (as planned), this special client reaped a huge financial payout. It is still not clear whether this was strictly illegal --- all kinds of fraudulent practices that are morally suspect have been found to be within the current laws that protect private contracts. Which is all the more reason Congress needs to get cracking on serious financial reform. The time is ripe to push the envelope. Even the Republicans recognize that somebody has to pay for this latest outrage.
‘Designed to fail’ investments represent one of the many perversions that are encouraged by Wall Street’s risk-spreading practices. Mortgage-backed securities severed the traditional ties between loans and lenders. Individual debts were sold to others who bundled them together to create new assets. These new assets were given Triple A ratings by agencies that, incidentally, worked for the same investment firms that created the mortgage-backed securities. These securities were supposed to spread risk around, spurring more innovation. But what they did was pass the risk along, making it harder to hold anyone accountable when deals went bad.
Securitization also allowed financial institutions and insurers to create assets that had no real capital underneath them. For example, mortgage-backed securities were insured to protect investors against possible default. However, the insurers did not have enough capital on hand to cover potential claims. To get around this, insurers created ‘derivatives,’ which are financial assets that are derived from the value of another asset. When the assets upon which the derivatives were based went bad, the value of the derivatives also plummeted. These became the 'toxic assets' that brought down Lehman Brothers and led to the massive bailout of AIG.
The ‘credit default swap’ is an especially problematic instrument that shields managers from the true risks of their speculative behaviors. This is the essence of the CDS: one party collects a fee for promising to insure a bond while another party makes the premium payments and gets a big payoff if the bond goes bad. The ‘synthetic collateralized debt obligations’ we are now learning about --- ones where investors can bet on assets they don’t own, and where the value is based on a derivative of a derivative --- take the default swap to its logical extreme. I like this analogy, from Roger Lowenstein: It's as if your neighbor takes out insurance on your life, and gets a big payoff if you die.
When investors have no stake in the underlying financial instrument, they take enormous risks that can destabilize the economy because the potential short-term payoff is very big (this is what we call a 'perverse incentive,' and real reform needs to change the incentive structure). The current rules allow this; and so does the current ethos. We need a change in the
rules that govern Wall Street and the culture that continues to dominate: the vulture culture where financial titans do not have to take into account the long-term impacts of their actions.
The financial sector is no longer doing its job, which is to invest in the real economy’s productive capacities by raising money for industry and services. Instead, the titans of the financial sector are running gambling tables with money that should have been reinvested in the real economy. Since we, the public bailed them out (and have been doing so for over thirty years, and most likely will do so again), they are gambling with our money, as well as our economy's future.
What can we do about it? Insist on real regulatory reforms that bring the financial sector back in line with its original purpose --- to serve the real economy. In addition to contacting your Senator, join the movement for fundamental changes in the way our financial economy works. Visit the Showdown in America for information about the many events that are taking place around the country. Workers, farmers, community activists and others are putting ‘feet to the street’ to illustrate what needs to happen to get our economy back on track. If you can get to New York City next week, thousands of people will take the fight to Wall Street’s door. Meet me on Wall Street on April 29 at 3pm.
---Sandra Hinson
