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Financial Market Alchemy

Turning Junk into Gold

Mary-Jo Kranacher, MBA, CPA/CFF, CFE

Most investors, especially sophisticated ones, should be able to tell a good investment from a fraud; but when their judgment and instincts fail, the U.S. regulatory system should be expected to protect their interests. However, the recently released report, “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse,” based on the work of the Permanent Subcommittee on Investigations, chaired by Senator Carl Levin (D-Mich.), exposes shortcomings in our capital markets and explains in detail how a culture of greed and deception managed to undermine our financial system and our economy.

Although most would snicker at the prospect of turning junk into gold, a few major players demonstrated a knack for alchemy in a market where highly rated investments were turning to junk.

High-Risk Lending and ‘Too Big to Fail’

The Levin report begins by providing an example of the banking industry's highrisk lending practices—the case of Washington Mutual (WaMu). In a quest for increased growth and profit, WaMu loaned money to risky borrowers; predictably, this resulted in high rates of default. Qualifying borrowers for larger loans than they could afford, steering home buyers to mortgages with short-term “teaser” rates, and approving mortgage applications with no verification of income or assets were just some of the reckless practices that bankers used to market their products. Some of the loans were not simply poor quality, they were downright fraudulent—the borrower's income was misrepresented or the appraised value of the mortgaged property was overstated. As shareholder confidence crumbled, WaMu's stock price plunged, depositors withdrew their money, and a liquidity crisis ensued.

WaMu also polluted the financial markets by securitizing its subprime loans and unloading them on unsuspecting investors or selling them to Fannie Mae or Freddie Mac. By September 2008, WaMu's losses had grown so large that its failure could have drained the entire balance of the Deposit Insurance Fund—$45 billion.

Inflated Credit Ratings

Because of the growing complexity of structured financial instruments, U.S. markets depend on credit rating agencies (CRA), such as Moody's or Standard & Poor's, to evaluate the default risk level for these securities. The most highly rated (Aaa or AAA) securities exhibit low volatility and high liquidity, indicating a relatively safe investment. For years prior to the financial crisis, CRAs gave subprime residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDO) their highest ratings, leading investors to believe that these structured financial transactions contained little risk. Although the mortgage industry's investment-grade credit ratings were ultimately found to be unjustified, it took the CRAs a long time to acknowledge their slipup and adjust the ratings accordingly. This delay allowed the big banks the time and cover they needed to unload these toxic assets. A cynic might suspect that the reason for this delay was caused, at least in part, by the conflict of interest inherent in the “issuer pays” model of credit ratings.

Goldman the Alchemist

WaMu worked with several investment banks to underwrite and sell its securities. Among them was Goldman Sachs, the lead underwriter for its RMBSs. Goldman collected lucrative fees to help securitize these high-risk securities and then obtain investment-grade credit ratings for the resulting structured financial instruments. After selling billions of dollars of risky mortgages into the financial markets, Goldman then used credit default swaps to benefit from the failure of the same securities it sold to investors. While the subprime mortgage market was in freefall throughout 2007, Goldman generated net revenues of $3.7 billion from large net-short positions in mortgage-related securities.

According to the Levin report, Goldman also promoted “its own interests at the expense of investors” by trading “for the benefit of the firm without disclosing its proprietary positions to clients.” In addition, Goldman's Abacus marketing material did not disclose that Paulson & Co., one of the company's largest customers, had helped hand-select the assets in the CDO at the same time it had taken a substantial short position in this structured transaction. This lack of disclosure also explains why investors were unable to recognize the swindle.

The Levin report concluded that Goldman Sachs engaged in “troubling and sometimes abusive practices that raise multiple conflict of interest concerns” and, consequently, was able to realize financial gains at the expense of others.

We know that alchemists never really could make gold, but apparently Goldman has found a way.

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA/CFF, CFE. Editor-in-Chief. ACFE Endowed Professor of Fraud Examination, York College, The City University of New York (CUNY), mkranacher@nysscpa.org.

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