Arnold Kling  

Why Did We Save the Financial System?

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Steven Randy Waldman explains the infamous Goldman transaction.


the notional CDO forms the basis for a thought experiment: Given any performance scenario for debt in the reference portfolio, we can compute the loss that would have been experienced by holders of the various tranches. So, we could write a kind of swap (somewhat different from an ordinary credit default swap), whereunder a "protection buyer" pays a predetermined, fixed spread and a protection seller pays the losses that a hypothetical holder of a tranche in the notional CDO would have experienced.

My initial reaction to the Goldman lawsuit was that the nature of the transaction was beyond my depth. Reading Waldman's post confirms this.

Incidentally, I am not stupid. Nor do I lack a background in finance. Among other things, I have read Marcia Stigum's treatise on money markets, worked through Robert Merton's lecture notes from his graduate course, and read Robert McDonald's graduate textbook on derivatives. And I have close to no idea what Waldman is talking about.

But I put it to you that this transaction was part of a financial ecosystem that did not create value for the rest of the economy. Rather, it developed initially to create regulatory capital arbitrage, meeting the demand for AAA-rated securities created by simplistic, world-wide bank capital regulations under the Basel Accords. Starting from this central purpose, the structured transactions industry evolved to the point where deals like the Goldman Abacus "security" were created.

And this is the financial system that Ben Bernanke and Henry Paulson are credited with saving. My question is, why was it so important to save this system?

I had a relative who suffered from severe mental illness for many years. One day in despair, she jumped off a bridge into a river. A bystander dove in to attempt to save her, but it was too late.

It seems to me that Wall Street suffered from mental illness in recent years, and the financial crisis was its attempt to commit suicide by jumping off a bridge. Bernanke and Paulson tried to save Wall Street by throwing the taxpayers into the river.

I appreciate what the bystander did for my relative--he was trying to save a woman's life, at some risk and discomfort to himself. But in the case of Wall Street, I do not think that the mentally ill financial system should have been saved from its suicidal impulses.


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COMMENTS (6 to date)
Matt writes:

Also, your heroic bystander threw himself in the river, not other people. Maybe Buffet deserves a pat on the butt for throwing himself in, but Paulson and Brenanke deserve to be chastised.

Biagio Mazzi writes:

While I fully agree with the idea that structures like the one described above add very little value to the economy, I don't agree that they constitute the entirety of the financial system that was at risk. Had Paulson and Bernanke not stepped in, a whole array of perfectly useful tools from vanilla securities to vanilla derivatives would have been affected. To push your similitude a little further, it was not a mentally ill individual jumping off a bridge, rather a mentally ill individual driving a bus load of sane people off a bridge. We needed to save at least the sane people.
Some people (I read an interview of Krugman that seemed to implied that) believe that no financial derivative is of any use whatsoever, in that case I can see how some might think we should have let the bus go.

DougT writes:

In agreement with Biagio, these were transactions on the margin. Just because *some* of what banks do is regulatory arbitrage, it does not follow that *all* of what banks do is regulatory arbitrage.

In a broader context, regulatory arbitrage does provide a useful social function in that it points out (via profits) the logical inconsistency of regulation. Also, short-selling is similar to CDS protection in that they provide a way for financial participants to "speak truth to power."

fundamentalist writes:

I disagree that Kling doesn't understand CDOs. I would guess that Waldman doesn't understand them well enough to write clearly about them.

Hunter writes:

Perhaps it is just the wording, but the swap described above sounds like nothing more than an equity swap except in this case the underlying asset is debt (i.e. an equity swap pays the total return of a stock/indext/ect. in return for (generally) a floating payment. This sounds very much like what is being described above except that it pays the total return on a CDO tranche) If this is correct, it sounds rather harmless.

Mala Lex writes:

So long as bailouts are on offer, the rest seems deck-chair-on-titanic to me. In theory one could calibrate the bailouts - exclude some items, reduce the size of each bailout (ie too-big-to-fail), but public choice says the bailouts, once they exist, will tend to expand. Concentrated benefits, and when the costs do show up on the radar they have the economy as hostage.

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