Goldman on Trial - Part 2

In Part I, we discussed how the lawsuit against Goldman would serve more as a distraction than a resolution to the massive loss of wealth the world experienced. To fully understand what happened, it’s important to remember a couple of lessons we learned back in the 1980s.

Do you remember at the end of the Breakfast Club, when Claire started making out with Bender? It’s easy to understand why she did it. They had been cooped up in that library all day, revealing their cigarette burned souls to each other. Plus, if you're Claire, there's no better way to piss off your parents than to make out with a guy right in front of their car, as they come to pick you up from detention. Claire was feeling good; she was breaking the rules. But come Monday, you knew it was going to be awkward. How was Claire going to explain this to her friends? She didn't need this – not in her senior year.

That’s where the rating agencies come in. Our public pools of money can often act irrationally, in a way that has consequences in the long run. For decades, our public money sat in the safest types of bonds: Federal, Provincial, State, Municipal, and certain commercial bonds. A combination of regulation and ratings created a fence around the money, so it can't chase Benders.

The rating agencies issue a rating for each bond, and pensions are permitted to invest in only those bonds that have a high "investment grade" rating. In the past, the our pensions never invested in derivatives; they were real bonds that belonged to a single business. Ultimately, it is the rating agency’s blessing that allows our large pools of public money to be invested in anything.

There is something else from the 1980s that is critical to the story: Junk Bond trading. Investment banks were making a ton of money trading Junk Bonds. Traders discovered a profitable phenomenon. Because these bonds were rated poorly by the agencies, it meant that public pools couldn't buy junk bonds. But the public pools of money were so large and they represented such enormous demand, that it created a large disparity in the bond market. The demand for investment grade bonds was inflated in value, while the market for junk bonds thinned out so as to provide ample buying opportunities. Throughout the eighties, traders would buy junk on the cheap and profit with patience. Then a man named Fred Carr did something crazy.

In 1989, Fred Carr created a Collateralized Bond Obligation that changed the landscape of junk bonds forever. Carr worked at First Executive bank, and like every other bank at that time, they held a large portfolio of junk bonds. At the time, regulations required Carr to fully finance his reserves for these junk bonds. In other words, regulators were concerned that these junk bonds might default, so they made First Executive keep cash on hand, in case they failed. For every dollar of junk you hold, you must set aside a dollar in your vault. This was to ensure that First Executive could continue operations in case the bonds defaulted, or could not be sold due to market conditions.

Carr took all his junk bonds and pooled them together into a new corporation (Special Purpose Entity). Once all the junk bonds were in a separate entity, that SPE issued three types of shares. Class A would be guaranteed a return of 4%. Class B would get a return of 6%. The final class would get whatever was left over, and was by far the riskiest class since it was not guaranteed to get anything.

Carr knew that the risk of all the junk bonds defaulting at once was low. By pooling all the junk bonds together, he created a new financial instrument. Sure, maybe one or two bonds in the pool might default, but most of them would be fine. In the new pooling scheme he created, he could easily promise the first two share classes a reasonable return, while leaving the risk to the final share class that may or may not benefit - the risk of those few bonds defaulting fell entirely on the last share class.

After creating this new corporation that was made up entirely of junk bonds, First Executive proceeded to purchase 100% of the SPE. In reality, First Executive had the exact same portfolio as it did before the transaction. However, the way he had designed the shares of the new corporation (A & B shares being promised a fixed return, while the final share class bore all the risk of default), he was able to get around the reserve requirements. The first two share classes of the CBO would be rated highly by the rating agencies, and only the riskiest share class (aptly referred to as “toxic waste”), would receive a junk rating.

Previously, First Executive had to keep cash on hand for the entire pool of junk bonds. Now, they only had to set aside money for the riskiest share class. As a bank, there is an inherent advantage to keeping fewer reserves. It means they can lend more of their cash on hand, which means they can make more money. The risk to First Executive was exactly the same as before, yet by changing the legal form of their portfolio, they had persuaded the rating agencies using the junk bond logic of the 1980s.

For the next 20 years, everyone is doing what Carr did, except they're using mortgages, car loans and credit cards. Because the first two share classes receive the good credit rating, the public pools of money could now buy these products. And buy it they would. That public money has an insatiable appetite for above-average returns with investment grade risk. Add to that, it was in the bank's interest to facilitate these deals because they were incredibly profitable.

Rating agencies, often thought of as gatekeepers, opened the doors so our money could participate in credit pools that were previously restricted. Imagine, if you were Claire, and you showed up to school on Monday to discover that all your friends suddenly had a big crush on Bender. At that point, you don’t ask why; you just go for it.