SEC v. Goldman Sachs: What the Case Is Really About

The SEC's fraud case against Goldman Sachs, and Goldman's defense, reflect competing views of the way federal regulation of the financial markets should work. While we have no inside information about how either party plans to argue its side of the case, the information that's already public indicates the lay of the land. Goldman contends that it gave "extensive" disclosure to "sophisticated" investors and they should thereafter be held responsible for themselves. The SEC's argument is Goldman's defense doesn't address the way investments are sold in the real world and that, in reality, Goldman misled investors.

A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.

The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.

The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.

It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.

Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.

Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.

U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.

As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.

There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.

The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.

Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.

The SEC's Case: Goldman, Too, Danced to the Music

Today's enforcement case by the SEC against Goldman Sachs for allegedly making misrepresentations in the marketing of a synthetic CDO called ABACUS 2007-AC1 signifies many things. Goldman hasn't formally responded in court, but has denied certain assertions by the SEC. We won't attempt to predict the legal outcome at this early stage. But a few observations seem fair.

First, the case signals a return by the SEC and its Division of Enforcement to the big leagues, after a painful stint in Triple A. The agency will be on the front pages of newspapers tomorrow--this time in a positive light. Of course, the SEC needs to get a good result--victory at trial or a favorable settlement. But its willingness to take on the most imperious doyenne on Wall Street--which couldn't even get its CEO on the train from New York to Washington for a meeting with the President late last year (are they now rethinking that one?)--reflects pugnaciousness badly needed in the regulatory structure.

Second, the case will strengthen the movement toward reforming financial regulation, with a special nod in favor of the Volcker rule--there's really no good reason for insured deposits to subsidize this sort of behavior. Additionally, the two principal victims were European banks. The SEC charges will only fuel the already robust movement in Europe to rein in the Wild West antics of the derivatives markets--in part because the case broadly echoes Goldman's reported role in helping Greece pretty up its balance sheet, thus effectively increasing Greece's risk of overextending itself, and then creating a trading vehicle in London to short sell Greece.

Third, regardless of whether or not Goldman is legally liable, one has to wonder what on earth Goldman's management was thinking when they signed off on this deal? By early 2007, when the deal was done, Goldman was aware of the growing weakness in the mortgage markets. Certain e-mails were quoted in the SEC's complaint which make that clear and Goldman hasn't denied the contents of the e-mails. When a bank knows a market is poised for problems, why structure a deal that involves selling long positions in that market? Surely there are less problematic ways to make money. Goldman made $15 million in fees for structuring this deal (although it claims to have lost $90 million in the end). It could pay out a lot more than $15 million to injured investors if it loses at trial. And even if it turns out that Goldman didn't break any rules, why would it have benefited from putting clients in a position of significant potential for loss? These weren't dot com IPOs. These were interests in mortgages, supposedly a pretty safe investment. Clients would reasonably have expected that they wouldn't be put at major risk by a silk stocking firm like Goldman when they were looking for comparative safety.

The old Goldman Sachs (primarily, the firm before it went public), had a strong sense of self-awareness and propriety, turning away from many deals and their potential fees simply because they would have been too risky for clients and therefore too risky to Goldman's reputation and standing. Today's Goldman seems to have lost that sense of judgment and moderation.

What may have really been going on, we speculate, could be that Goldman wanted the fees. Although $15 million isn't much for an investment bank that makes billions a year, it is a lot to individual Goldman executives, like the man who was named as a defendant by the SEC, Fabrice Tourre. Tourre, alleged to be 31 today, was in 2007 exactly at the young age where ambitious investment bankers push extremely hard to climb the career ladder toward anticipated stardom--old enough to have significant responsibility and latitude, but frequently not enough experience to know that cents and sense--especially common sense--are very different things. Young, high powered execs will push, push, and push their deals because they're focused on bonus time. But a mature financial institution can't just knuckle under to its young guns. In a highly visible and highly regulated industry like financial services, how you generate revenues matters as much as how much you generate. Chuck Prince, former CEO of Citigroup, famously said (and we paraphrase) that as long as the music in the mortgage markets was playing, Citigroup had to get up and dance. It did, and it got clobbered. Now we have Goldman, by early 2007 seemingly aware of the growing difficulties in the mortgage markets, yet also wanting to dance while the music was playing.

The nightly cleaning crews at Goldman's offices surely earn modest wages. But those are honest wages earned in exchange for a fair night's work. With today's allegations about ABACUS 2007-AC1, we have Goldman, which has tried for decades to present itself as a cut above all those scumbags on Wall Street, not comparing well to its cleaning staff. Goldman was supposed to be smarter, a protector of clients' interests, a firm that took the long view and would forgo current income for the sake of propriety. Its elite, blue blood aura provided special entree in Washington, as well as on Main Street. People thought of Goldman as clever, very quick on its feet, highly profitable, yet thoughtful before it was greedy. That bubble has now burst, and GS is revealed to have feet of clay. On one level, that's reassuring, but on many others, it's not. Expect financial regulatory reform legislation to be enacted by the mid-term elections.

Speculating with Derivatives in the Mortgage Markets

News reports tell us that a third Bear Stearns hedge fund that invested in mortgage-backed securities has suffered serious losses and stopped honoring investor requests for withdrawals. A number of hedge funds are reported to have suffered losses in the mortgage markets. Among those affected are funds operated by hedge fund veterans Paul Tudor Jones and Bruce Kovner, who were tangling with market volatility when many of today's newer hedge fund operators were dabbling in acne remedies. European banks have reported sizable losses, as have Australian hedge funds. Mortgage brokers and mortgage companies have suffered heavily, and bankruptcy lawyers are sharpening their pencils. The financial press hints at many more losses yet to be reported.

The cascading losses from the subprime mortgage mess reveal a flaw in the rationale commonly provided for derivatives. Derivatives are said to be socially beneficial because they diffuse risk and place it in the hands of those that want to carry that particular risk. The impact of losses is spread out and market volatility is damped. It all sounds good.

But if losses are diffused, then how could all these big players in the financial markets have been clobbered as badly as they were? Or, in a few cases, forced to file for bankruptcy?

Derivatives have sometimes been used as hedges, and many of the earliest derivative contracts were conceived as hedging mechanisms. Why didn't the hedge funds hedge their mortgage market exposures? There are so-called credit derivatives contracts that are like an insurance policy against a CDO default. A hedge fund or other investor that had held CDO credit derivatives when the yogurt hit the fan would have been out of pocket the cost of the credit derivatives. But that beats paying midnight retainers to bankruptcy lawyers.

The apparent answer is simple, if disturbing. Derivatives contracts, although in many cases originally developed as hedging or risk shifting mechanisms, are now frequently used to speculate. Investors can start off with a neutral trading position and invest in a derivatives contract that gives them exposure they hope will be profitable. In other words, they seek out risk. This is the opposite of hedging.

Hedge fund operators appear to have used CDOs holding subprime mortgages largely for speculative purposes. Although these investments are risky, they'd probably have been priced at attractively low levels that would allow for big potential returns.

The fact that derivatives contracts can be leveraged also would have played a critical role. In a world flush with cash (until perhaps recently), it would have been easy for the hedge fund kings to line up credit from investment banks to buy derivative contracts sold by the investment banks that were offering credit. (Furniture stores do the same thing--sell you their sofas and love seats on the installment plan; but sofas and love seats usually don't turn around and bite your butt into bankruptcy.) With the availability of easy credit, hedge funds could leverage up their derivatives speculations, and go in for a dollar instead of a dime.

Using credit-financed derivatives to speculate takes us to the back hills of Virginia, into hollows and ravines where moonshine is still made by truck driving men who don't talk a lot, and who transport it to Washington by the light of the Big Dipper to be sold to select bars where you can get a taste of white lightening if you know what to ask for and how. Leveraged speculation in derivatives is 180 proof stuff, and so potent you might not even taste it. You'd just get a burn in your mouth.

Although hedge fund operators are aggressive, why would they take such large risks? In part, the answer probably involves things like ambition, testosterone, hubris and an affinity for adrenalin rushes. Some soldiers like the thrill of combat, even though the consequences can be extremely prejudicial.

But a crucial part of the answer is competition. Hedge funds compete with, of all things, index funds. The hedge fund industry has grown exponentially in the last ten years. As experienced investors know, the more money that crowds into the field, the fewer good investment opportunities there are. Thirty years ago, the Peter Lynchs of the world could drive around their home towns, see which fast food joints were drawing big crowds, and figure out what companies to invest in. Investing has become a lot harder than that. Hedge fund operators who just read 10-Ks and annual reports will have a tough time surpassing the S&P 500. In that case, why would their clients pay them 2% of assets and 20% of returns? The Vanguards and Fidelitys of the world are much less expensive and a whole lot less risky.

So the hedge fund guys need to use leverage and invest in alphabet soup esoterica like CDOs, CLOs, etc. in order to have a shot at beating the indexes. And hedging their exposure would only reduce the potential for them to beat the indexes. If you hedge, you necessarily start to lose money roughly around the same time you start to make money. You can try to play the game of investing in arbitrages a la Long Term Capital Management, in the hope of probably making small amounts of money at the risk of possibly losing large amounts. But that, too, requires leverage if the returns are going to give you bragging rights.

So, it would appear that the hedge funds and other mortgage market players must have made unidirectional hope-these-CDO-things-work-out bets. Maybe they had some hedges, and maybe they had other investments that were unrelated (or, "not correlated" in the parlance of risk management junkies) to the mortgage backed investments they had. These holdings would have provided some degree of protection or diversification. But, net net, if you don't take some above average risks, you won't get above average returns. So these folks eventually had to place their chips on either red or black.

Some hedge fund investors may have thought that the hedge fund operators had special insights or could do especially diligent research. And it would not be surprising if some hedge fund guys may have encouraged such beliefs. But, with a large, mature market such as mortgage backed securities, is it really likely that a 36-year old newly minted hedge fund operator, founder of the 2,500th hedge fund to be created in the last ten years, would truly have an informational advantage over the rest of the herd?

So, where does this leave us? First, if we didn't figure it out after the 1998 Long Term Capital Management bailout, let's figure it out now: the derivatives market is as capable of reckless irrationality as any other market, whether it be dot com stocks, real estate or tulip bulbs. The old chestnut that derivatives disperse risk and damp volatility has gone the way of the American Chestnut. Say it now and say it loud: derivatives are speculative instruments.

Second, even though the tamales in the debt and derivatives markets are getting red hot, no one knows who's going to end up holding them. These markets are substantially unregulated; there's no disclosure or reporting. The yogurt has hit the fan, but none of the Fed, SEC, Treasury, CFTC or any other governmental body knows where it will land.

The lack of transparency is not lost on investors. As we noted at the beginning of this blog, investors in a third Bear Stearns fund were sending in so many withdrawal requests that Bear Stearns ceased to allow withdrawals. That's akin to an old-fashioned run on a bank, where the bank simply tells the depositors to go home. Closing the doors doesn't reduce investor anxiety. If anything, it may heighten it. But we're no longer in the 1930's and Jimmy Stewart isn't with us any more to calm things down.

As a practical matter, we can only wait and see how things turn out. If they turn out badly, perhaps we can hope that the Fed's likely interest rate cuts give us a real-life Miracle on 34th Street. But some things happen only in the movies.

Record News: let's get away from this Barry Bonds stuff for a moment. The kazoo record seems safe. http://www.wtop.com/?nid=456&sid=1208243.

Those Pesky CDOs and How They're Ruining the Party

You may have read about CDOs in the financial news recently. They're the investment where investors (mostly institutions like hedge funds, pension funds and the like) purchase interests in the stream of payments coming from a pool of mortgages and other loans. Rising delinquency rates among mortgages, especially subprime mortgages, have led to losses for CDO investors. A pair of big losers were two hedge funds sponsored by the investment banking firm, Bear Stearns, which last week announced that the funds had lost all (in the case of one fund) and over 90% (in the case of the other fund) of their investors' money. Less than six months ago, these funds reportedly had more than $1.5 billion in investor money. But now, it appears that anyone that invested in these funds is holding nada, or darn close to nada.

The investors in these two funds have plenty of company. Press reports indicate that lots of investors and maybe some financial firms have lost money in the CDO markets. Lots of it. Chairman Ben Bernanke of the Federal Reserve reportedly said on July 19, 2007 that some estimates of the losses from the subprime lending mess could run up to $50 billion to $100 billion.

Even these days, $50 billion plus is more than lunch money. Many of the losses appear to come from mortgage loans that were poorly conceived. Adjustable payment loans with low initial "teaser" rates offered to borrowers with shaky credit histories, along with little or no documentation of the borrower's ability to repay the loan, created a scenario where the lender (or, more precisely, the investors in the funds that bought interests in CDOs) were speculating on a continuation of rising real estate prices to ensure repayment of their investments. This risk was heightened by funds that used leverage to increase the quantity of high risk mortgages they held--the greater the leverage, the lower the delinquency rate on the mortgages that would be required to blow up the fund. Of course, as long as the real estate market kept rising, things would have remained copacetic. And we all know that once a market starts rising, it never stops. At least, not for a while. A lot of very smart people were involved in creating the subprime mortgage, CDO situation, but the strange thing is that they didn't seem to see this train wreck coming. Or, if they did, they surely didn't do enough to stop it.

Whenever a tamale heats up, it gets passed around because no one wants to be burned. Put another way, chickens are of the habit to come home eventually to roost. It's safe to assume that the investors that have recently been told that they lost 90 or 100 cents on the dollar won't just sit quietly and sip some tea. Lawyers of the plaintiffs persuasion are now surely boning up on the fine points of CDO investments, while lawyers of the defendants persuasion are now surely boning up on the fine points of CDO investments. Well, at least someone will benefit from this mess.

As for Mom and Pop, standing somewhat bewildered behind the counter of their store at the corner of Main and Elm Streets, things will change. Easy credit, especially in the mortgage markets, will dry up, because Wall Street investors will refuse to buy easy loans. With interest rates rising, fixed 15 and 30 year mortgages make more sense anyway. People with weaker credit histories may be unable to get mortgage loans. But if the only loan they could get was a snare that would ruin their finances and wreck their lives, perhaps it's better if they spend a few years building up some savings for a down payment and improving their credit ratings. See our blog on how the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.

It was the availability of cheap credit that allowed risky mortgage loans to be made, and then packaged into CDOs that were the subject of investment strategies offering little more than a speculation on real estate values. The torrent of cheap credit that flooded the world in the last few years is drying up. European and Asian governments have been raising interest rates. While the Fed has held rates level for the last year, it by all indications is more likely to raise them than lower them. Easy money seemed to come in the last few years from owning real estate or, more recently, investing in blue chip stocks. A lot of people spent their home equity while real estate prices were rising. This almost casual use of home equity-based credit epitomized the adage, "easy come, easy go." But real estate values are flat or dropping in many markets and there's not likely to be much more easy money in the foreseeable future. At the risk of sounding like Ward Cleaver talking to the Beaver, caution and prudence in finances are now advisable. The thrifty squirrel has the best chance of surviving the winter. Store up some extra acorns, and sleep better.

For more detail about CDOs, read our blog at http://blogger.uncleleosden.com/2007/06/subprime-mortgage-mess-on-wall-street.html.

Animal News: More evidence that a pooch is your best friend. http://www.wtop.com/?nid=456&sid=1196569.

The Subprime Mortgage Mess on Wall Street

You're probably familiar with the problems on the home front created by subprime and other adjustable payment mortgages. Monthly payments are rising. Many homeowners are defaulting, and some face foreclosure. The problems are particularly acute in areas where housing prices rose abruptly and have now plummeted, or where economic distress is spreading.

The pain has spread to Wall Street. In the last week, the financial press has reported on difficulties at two hedge funds sponsored by an investment bank called Bear Stearns, which had invested indirectly in subprime mortgages. Bear Stearns agreed to provide a $3.2 billion loan to stabilize one fund. It's unclear what will happen to the other fund. What's going on here? How did we get from some defaulting homeowners in places like Michigan and Florida to a $3.2 billion bailout on Wall Street?

Here's an overview. We are speaking generally, and not about the Bear Stearns-sponsored hedge funds.

Fifty years ago, mortgage lending was primarily done by specialized banks usually called "Savings and Loan Associations" or "Building and Loan Associations." Broadly referred to as thrift institutions, these specialized banks held onto many or most of the mortgage loans they made. They earned profits from the difference between the interest they paid to depositors and the higher interest rate they charged for mortgage loans. Interest rates were stable in those days, and thrift institutions were able to make a comfortable living without working real hard.

In the 1970's, however, interest rates began to fluctuate widely, and the thrifts had a harder time maintaining profits. Regulatory restrictions on them were loosened in the early 1980's, but that resulted in a some poorly conceived lending strategies that led to the collapse of a number of thrift institutions. By 1990, the thrift industry was diminished and other players, like mortgage companies and banks, began to make more mortgage loans. They, however, did not hold onto the loans, but instead tended to sell them.

A mortgage provides a flow of cash, and can be bought or sold like a bond or other investment providing a cash flow. Investment banks pool large numbers of mortgages together into an entity often called a CDO (or collateralized debt obligation). These mortgage pools provide a large, aggregate flow of cash. Investment banks "subdivide" the aggregate flow of cash into classes called "tranches." Each tranche has different claims on the cash flowing from the pool of mortgages. The result is a tier of tranches, with the most "senior" having the best claim to the cash flow from the mortgage pool, the next most senior having the second-best claim, and so on, down to the most "junior" tranche, which basically has a speculative claim to the residual value of the pool.

The CDO issues bonds that correspond with the various tranches. The most senior bonds have the best claim to payment from the mortgage pool. The next most senior bonds have the second-best claim, etc. The potential returns from these bonds varies by the position of the bond in the hierarchy for repayment. The interest paid on the most senior bond will be the lowest, since its likelihood of repayment is the highest. The interest rate on the more junior bonds will increase, since they have greater risk of not being fully repaid. The most junior bond may even be called the "equity tranche," a term that reflects its high risk levels (not unlike the risks of equity investments like stocks).

Why did Wall Street create these CDO's? Because subdividing the mortgage pool into different tranches allowed them to sell a variety of investments that might serve the needs of different investors. Some investors want conservative, reliable investments with a low risk of default. They would be interested in the senior bonds. Other investors want bonds that pay a higher return, even if there's a greater risk of default. They'll take the risk of the default in order to get a better return, and would be interested in the more junior bonds. Some investors want to speculate, and the equity tranche, with its high returns and high risks--might fit into their strategy.

There has been, as you probably know, a hedge fund craze in recent years. Hedge funds have proliferated, and as their numbers have grown, their interest in new and different investments has grown. CDOs have drawn their interest. Hedge funds have borrowed, sometimes heavily, to invest in CDO bonds. Borrowing increases the quantity of bonds a hedge fund can buy and therefore leverages the returns it might receive if all goes well. However, borrowing also leverages the losses the hedge fund would receive if things go badly.

Things have gone badly. The real estate boom is over in most markets and defaults are occurring at well above normal levels. CDOs aren't receiving the cash flow they expected, and CDO investors like hedge funds are taking losses. Those that invested on a leveraged basis may be taking sharp losses.

How did this happen? On the most basic level, the market pros didn't correctly predict the level of defaults. That means they over-estimated the investment quality of many CDO bonds, and priced them too high. Losses are now resulting.

Who's responsible? Homeowners who took out mortgages they should have known they couldn't pay? Mortgage brokers, mortgage companies and banks that made loans to people who shouldn't have qualified? Investment banks packaging CDOs that didn't look close enough at the quality of the mortgages they were buying? Investors that borrowed to invest in illiquid assets like many CDO bonds? All of the above? Now that things are hitting the fan, Congress is holding hearings, government agencies are investigating, and lawsuits will be filed.

There has been very little regulation of the mortgage markets, especially at the Wall Street level, where hedge funds roam unsupervised among herds of CDOs. An absence of regulation sometimes allows markets to grow and evolve more quickly. But markets are created by humans and are therefore capable of error (as is evidenced by all the bubbles, booms and busts of recent years). The enormous growth of the mortgage market included many loans that never should have been made in the first place, and, once made, never should have been purchased for packaging in CDOs. Some of the losses from CDO investments are falling on wealthy individuals who invested in hedge funds to get money to buy a larger yacht. Such a shame. But other losses are falling on pension funds that ordinary people count on for retirement, or on university endowments that could help cover some of the costs of your child's education. In the end, many people will be hurt.

Congress, government agencies and state governments will be confronted by the question whether the mortgage industry should be more heavily regulated. If thrift institutions were still at the heart of the mortgage business, the problems we see today might never have happened. Thrift institutions were heavily regulated, and it's highly doubtful they would have been allowed to make the large numbers of low doc/no doc, don't-have-the-means-to-repay subprime mortgage loans that now weigh down on parts of Wall Street. Had those loans never been made, the losses wouldn't have occurred. And let's not think that subprime loans are a boon to home ownership. Extending loans that people can't pay and result in foreclosures not only doesn't increase home ownership, it damages the borrowers' credit ratings and impairs their future ability to own a home.

On an individual level, stay away from loans that have the potential for increasing monthly payments. As we discussed earlier, the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.

Animal News: the search for Bigfoot continues. http://www.wtop.com/?nid=456&sid=1175579.