The Financial Mess: Self-regulation is a joke

Damage from the bursting of the housing bubble was vastly compounded by an industry-wide conspiracy of Wall Street bankers to create a market for worthless financial products, in particular collections of mortgage bonds known as collateralized debt obligations, or CDOs.

According to the non-profit investigative news organization ProPublica, when faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks -- primarily Merrill Lynch, but also Citigroup, UBS and others -- "hit on a solution that preserved their quarterly earnings and huge bonuses: They created fake demand," buying and trading their own products to crank up an assembly line that in a prudently regulated economy would have been flagged to a stop.

As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

Individual instances of these questionable trades have been reported before, but ProPublica's investigation, done in partnership with NPR's Planet Money, shows that by late 2006 they had become common industry practice.

In the last years of the boom, CDOs had become the dominant purchaser of CDOs and CDO slices, in deals organized by the banks themselves that largely replaced legitimate investors like pension funds. For example, "[i]n the last two years of the boom, nearly half of all CDOs sponsored by market leader Merrill Lynch bought significant portions of other Merrill CDOs."

ProPublica also found 85 instances during 2006 and 2007 in which two CDOs bought pieces of each other's unsold inventory. These trades, which involved $107 billion worth of CDOs, underscore the extent to which the market lacked real buyers. Often the CDOs that swapped purchases closed within days of each other, the analysis shows.

There were supposed to be protections against this sort of double dealing, of course. The CDOs were overseen by managers who, though selected by the banks, were legally bound to protect the interests of the CDOs. Paid by the CDOs, not the banks, the "independent" managers were supposed to serve as a bulwark against self-dealing by the financial institutions, the only ones with even an inkling of how the complex and virtually unregulated mortgage bonds worked.

It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

Unfortunately for us, nothing in the Wall Street-dominated federal financial reforms will prevent it from happening again. What a laugh.

The rest of the story: Banks’ Self-Dealing Super-Charged Financial Crisis by Jake Bernstein and Jesse Eisinger (ProPublica 2010-08-27).

See, also: Wall Street's Big Win by Matt Taibbi (Rolling Stone 2010-08-04); Misnamed Financial Services “Reform” Bill Passes, Systemic Risk is Alive and Well by Yves Smith (Naked Capitalism 2010-07-26).