On hearings: The devil is in the details

The first session of the Congressional Financial Crisis Inquiry Commission is being called a success – like an NFL wild-card team that gets past the first round. Fans are mostly relieved that they weren’t embarrassed. 

The commission chairman, Phil Angelides, a former California state treasurer, scored at least a tie in a rhetorical standoff with Lloyd Blankfein, the formidable CEO of Goldman Sachs. 

But debating points don’t count. As long as the conversation stays at the 30,000-foot level – as this session did – the financial institutions win. 

The black smoke seeping up through the cracks suggests that bankers have been playing fast and loose with the spirit and letter of regulations and law. The repeated pumping and dumping of highly toxic instruments on so-called “sophisticated” investors, like small-state pension funds and school boards, has the smell of fraud. 

Bankers blandly wave away such imputations. Meanwhile, the already-faltering drive for tighter regulation is being conducted in a vacuum of critical data. This commission may have the last clear shot at digging deeply into the murk – searching through working memos, email trails, sales pitches, obvious conflicts – that might expose the actual skullduggeries, or possibly even clear the air. 

There are dozens of critical inquiries. What did Merrill and Morgan Stanley executives know about the outrageous practices at their subprime mortgage subsidiaries? Goldman was a major financial partner of AIG: What did its AIG credit team know about that company’s finances, at the time when they were marketing risky securities bundled with an AIG guarantee? 

Bank files will shed light on how huge dollops of bank leverage let private equity suck money out of performing companies to enrich their partners and fatten bank bonuses, while destroying jobs and leaving a trail of bankruptcies. 

Consider the now-notorious John Paulson housing shorts. Goldman Sachs and Deutsche Bank were hired by Paulson, a big hedge fund manager, to design some $5 billion of specialized credit default swaps that he expected to fail. The banks sold the swaps to its customers, though Deutsche didn’t unload all of its in time. When the swaps failed, Paulson made $4 billion, while the banks’ customers – apparently including a number of small pension funds – took a bath. 

Bankers smoothly explain this away as normal risk-spreading. Modern financial theory has carved out abstract notions of “risk” – risks of default, of interest rate movements, of currency shifts. There are deep markets in trading risk, especially in interest rates and currency “swaps.” The credit default swaps (CDS) at the heart of the Paulson deal, are among the newest risk-trading tools. 

Here’s how it works. Since bond markets are expensive and clumsy, CDS have become a favored way to simulate bond positions. An investor agrees to assume the default risk of a bond for a price – usually including regular quarterly or semiannual payments. The investor is now in roughly the same position as if he bought the bond – in financial jargon, he’s on the “long” side of the trade. He gets interest-like payments, much like a real bond holder, and bears the risk that the bond will lose value.