FT: Wall Street Opacity Survives

The Financial Times looks at how complexity and opacity plays into Wall Street’s hands at the potential expense of its clients.

We’re led to believe up high that we’ll learn about why this is bad through the example Peloton Partners, a highly leverage hedge fund that failed in 2008 when banks began calling in their loans:

The Peloton saga is a case in point. When the firm started to ail in early 2008, as the value of its investment fell, its counterparties at the big Wall Street firms marked the portfolio down to dramatically lower levels (simply “unrealistic”, the fund claims). While it was furious, Peloton had little recourse since it had signed a contract with the banks that gave them the right to value those securities unilaterally.

“The cards are all stacked in favour of the dealers,” says an individual familiar with the case. “The banks have both information and the incentive to push people out of positions and to kill their customers when they begin to smell blood.”

But the piece doesn’t go into much detail or tell us why we should sympathize with Peloton—much less tell us much of the story of its collapse, which it promises to do. And the sourcing there doesn’t cut it. It’s probably coming from a Peloton executive or lawyer, and if you’re going to use anonymous sourcing like that, you should tip the reader as to where they’re coming from.

The FT also doesn’t quite do a good enough job of pointing out that the question here is whether Goldman et al were simply smarter and more accurate in their pricing or whether their pricing was a sort of self-fulfilling prophecy, though we get hints of the latter here:

In 2007, when Bear Stearns was ailing, the second-tier Wall Street securities company was forced to sell mortgage securities to raise capital to support two of its affiliated hedge funds. However, as it made the sales, the prices of those securities collapsed. This was partly because of a fall in demand, but also because some rivals had trading bets that would pay out if the mortgage securities lost value, giving them an incentive to mark Bear Stearns’ books down – or, in trader jargon, to cut the “marks”.

“Every dealer gave us approximately the same valuation except for one firm with a big short position in those same mortgage securities,” says a former Bear Stearns executive, referring to Goldman. “They gave us marks that were 20 points below everyone else’s. The disparities in values are massive.”

In other words, Goldman (an Audit funder) priced a dollar’s worth of CDOs at, say 60 cents, while everyone else said they were worth 80 cents. By lowballing the price, Goldman forced its clients to fork over more collateral, which forced them to sell assets, which fed the downward spiral in price and helped make them actually worth 60 cents.

This is similar to what The New York Timeswas talking about back in February. And that points up yet another example of Goldman’s forked tongue. Here’s the NYT then:

Still, documents show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with A.I.G. required. And Goldman based some payment demands on lower-rated bonds that A.I.G.’s insurance did not even cover.

And the FT now:

AIG disputed the values, referring to documents that allowed each side to go to the market for alternative prices. However, the insurer’s executives say Goldman refused to accept prices from other dealers and eventually AIG had to “capitulate”. “AIG would not agree on a process to obtain third-party values,” the Goldman spokesman says. “The suggestion that we had an incentive to mark below market is wrong. We were prepared to trade at our marks and others, including the firms that AIG got indicative prices from, weren’t.”

It’s worth noting that the NYT also reported that BlackRock said in late 2008 that Goldman’s marks were “consistently lower than third-party prices.” And it flat reports this:

When A.I.G. asked Goldman to submit the dispute to a panel of independent firms, Goldman resisted, internal e-mail messages show.

Or take Deutsche Bank, as the FT does here:

In yet another case, during the course of 2007 the proprietary trading desks at Morgan Stanley and Deutsche Bank entered into a dispute about the value of a $16bn subprime CDO deal. Morgan Stanley valued the position at 95 per cent of its face value; Deutsche at 70. In the event, since Deutsche had lent money to the Morgan Stanley team as part of the deal, it was able to force through the lower price – creating a $9bn loss for the American investment bank. (Deutsche’s proprietary trading desk went on to make more money from that transaction. One of the consequences of the settlement was a fall in the value of such CDOs in general – a shift that played into the hands of the German bank’s traders, who had taken considerable short positions betting on precisely such a price drop.)

Who was actually right on the pricing? I don’t know and neither does Deutsche or Morgan Stanley. The point is the power that one bank has over the other and the conflict of interest that creates when that bank is betting prices will go lower.

The nut comes from the sidebar writing about the financial-reform bill and its effect on such issues:

A central reason why banks have enjoyed so much power, and profit, in recent years is that they have been able to control information flows in obscure corners of the market that politicians do not usually have the energy – or appetite – to probe. As things stand, that is unlikely to change.

No surprise there.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.