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Investment Banks: "Positively Evil"

|Includes: SPDR S&P Bank ETF (KBE), KCE, KME

Felix Salmon has written a good piece on the behavior of the investment banks that bought, securitized, and sold mortgages in the years leading up to the crisis (emphasis added):

...[Investment banks] tested only a small portion of the loans in [a] pool [of mortgages]. So [they] knew that if there were a bunch of bad loans [discovered by testing], there were bound to be even more bad loans among the loans that...had not [been] tested. And those loans it couldn’t put back to the originator, because [they] didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of [the] test[s]. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

Disconcerting stuff, though judging by a recent Bloomberg poll, it wouldn't surprise most Americans:

Wall Street financial firms and the mortgage industry get the most blame for the country’s economic weakness. More than three-quarters of the 1,000 Americans polled say the former has hurt the economy, while more than 80 percent fault the latter.

On a related note, Warren Mosler made the following observations in a recent presentation (pdf):

There is no public purpose served by allowing:

  • Banks to sell their loans
  • Sales of credit default risk when loans are based on credit analysis
  • Banks to engage in any secondary market activity
  • Proprietary trading

Mosler also observed that "Banking should be a lot more limited than even restoring Glass-Steagall implies," and that "The number of regulators needed increases geometrically with expanded bank activities." He also ably dissected TARP and the shortcomings in federal stimulus measures. As he cleverly puts it on his website, "The financial sector is more trouble than it's worth."

And indeed, some empirical studies support the argument that the financial sector has been a mammoth rent sucking machine for decades. But good luck doing anything about it. Its immense profitability and resulting political clout have made it a powerful lobby, which is reflected in many parts of the recent Dodd-Frank legislation, as well as the deregulatory push of recent decades. And the fact is, the activities that Mosler listed have made some people incredibly wealthy, and there are simply too many people who want their shot at a million or billion dollar carrot, social consequences be damned. In fact, few if any of them even have a clue that their activities are socially harmful or neutral at best. Nothing quiets one's conscience like visions of philanthropy, I suppose.

But despite the opaque complexities of the industry, people are on to it, as the Bloomberg poll shows. And the threat of pitch forks, however distant, might be at work in some recent industry actions, like the shutting down of proprietary trading desks and (tangentially) FINRA's proposal to allow investors to select an all-public panel of arbitrators. Time will tell.

Disclosure: No positions