Felix Salmon

Those evil synthetic CDOs

Felix Salmon
Dec 30, 2009 17:08 UTC

Yves Smith has another long broadside today against Goldman Sachs, Morgan Stanley, and any other bank which made money on synthetic CDOs. She links approvingly to yesterday’s NYT editorial, which concludes:

Unsavory and dangerous practices like firms betting against their clients need to be thoroughly investigated. They won’t end until Congress adopts ambitious financial reforms.

Narrowly speaking, this is false on both counts. What we’re talking about here is simply the world of structured products, in which broker-dealers use derivatives (always referred to in the press as “complex derivatives”, whether they’re complex or not) to create financial products for which their clients have some need or demand. Because derivatives are a zero-sum game, it’s trivially true that any bank selling such a product to its client is, at least in the first instance, betting against that client. If the client wins, the bank loses, and vice versa. Such practices may or may not be unsavory and dangerous, but they don’t need to be thoroughly investigated: everybody knows how derivatives work.

What’s more, such practices aren’t going to end if and when Congress adopts ambitious financial reforms. Structured products are with us, and they’re here to stay. Personally, I consider the overwhelming majority of them to be part of the enormous bucket labeled “harmful financial innovations”, and I would be very happy if they disappeared. But both the banks and their clients are utterly convinced that these derivatives are very useful things indeed, and as a result the only question is how they’re going to be regulated, not whether they’re going to exist.

Now it’s true that at the margin, the synthetic CDOs put together by Goldman were more unsavory than many other structured products, because of the information asymmetry involved: Goldman knew what the sausage was made of better than its clients did. But it’s worth noting, here, as Gillian Tett has explored at book length, that most banks putting together synthetic CDOs actually lost billions of dollars on those instruments. Now that we’ve pilloried Merrill Lynch for being so stupid as to get synthetic CDOs spectacularly wrong, we’re moving on to pillorying Goldman Sachs for the equal and opposite crime.

Remember that while Goldman did indeed retain a large short position in these synthetic CDOs, most of the shorts who fueled the market were not broker-dealers at all, but rather fund managers: Michael Lewis wrote a much-celebrated story about one such manager, Steve Eisman. Eisman was a client of the investment banks just as much as the investors on the long side were, and just as prone to problems of information asymmetry.

By far the most systemically-devastating decisions made by Wall Street over the course of the credit boom were the ones which ended up losing banks billions of dollars — and the ones which involved lending real money to real individuals buying real homes they couldn’t afford. Side bets in the derivatives market were ultimately a secondary or even tertiary phenomenon, and it’s easy to overstate their importance.

Yes, it would be good if the derivatives market were regulated somehow: I hope it is. But so long as there are profitable investment banks playing in this market, those banks are at heart going to be making money by betting against their clients. The banks know it, the clients know it, and most of the time all of them are happy — until, of course, they’re not. If bankers’ behavior in the the derivatives market ever changes, it’s more likely to be a function of having to deal with an increasing number of Chinese clients who get upset if they lose too much money, rather than a function of financial reforms being pushed through Congress.


The story you link to – great reading by the way – points out that pre-bust demand for synthetic CDOs was completely outstripping actual numbers of mortgages on the market, in direct response to which certain unethical major synthetic sellers generated more product to, as it were, satisfy that demand.

This would imply that somebody who issued them was not only betting against future values of said re-rated BBB CDO bundles qua AAA ones, but went about fabricating loads of additional pseudo-collateral out of raw cloth.

There’s a word or two for synthesis as evil as this. “Illegal” is the most polite one that comes to mind here.

Of course there were some losers among CDO issuers – most of them were never quite as off-the-map evil as GS, so destined to lose they were. If the pillory is all Goldman ever gets for their particular misdeeds leading more or less directly to precipitation of the mortgaged-backed CDO crisis, one might say they were getting off pretty damn lucky.

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The Daily Curator

Felix Salmon
Dec 30, 2009 15:45 UTC

Mick Weinstein, the editor-in-chief of Seeking Alpha, has unveiled his latest side project, the Daily Curator. And I love it. Mick says it’s a “pre-pre beta”, but I hope he doesn’t change too much besides the range and depth of content, because the gorgeous simplicity of the site makes it a joy to use.

The Daily Curator is basically a TechMeme for business and finance: Mick is scouring his Twitter and RSS feeds for the buzziest stories of the day, and aggregating the smartest discussions surrounding those stories. His Twitter list alone is invaluable; the Daily Curator homepage itself is like a beefed-up, real-time version of daily link blogs like Tadas Viskantas’s Abnormal Returns.

I suspect that this kind real-time, human-powered aggregation and curation (see also: Atlantic Wire) is going to become increasingly popular over the next year or two: it’s powerful, it’s relatively cheap (compared to the cost of sites producing original content), and there’s an increasing number of early-stage investors looking to make bets on disruptive content, especially as big financial sites like wsj.com and ft.com remove themselves from the conversation by putting up paywalls. I very much look forward to seeing sites like this one evolve, thrive, and multiply.

Update: Well, it was fun while it lasted. It’s down now.


seems like a good idea, but not vastly different from the many news aggregators out there. If you are interested in The Daily Curator, we’d invite you to check out etfdesk.com. We’ve taken a different editorial spin: let users post blog posts, news articles, research reports, economic data, etc and link ETFs that are “plays” on the themes in the articles. This creates an investment thesis which we then track for performance. In the aggregate it becomes a great research and starting point for macro investing, learning the many ways to use ETFs for all types of trading, hedging, asset allocation strategies…

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Right about earnings? Win a wiretap!

Felix Salmon
Dec 30, 2009 15:21 UTC

Prosecutors of white-collar crime are a bit like investigative journalists, trying to connect dots. But reading Susan Pulliam’s account of how the Galleon case was put together, I’m struck by how unprepossessing some of the most crucial dots were.

Andrew Michaelson was buried in paper, millions of pages of it…

When Mr. Michaelson’s team found the needle in this haystack of documents — a single text message — it pointed them toward Raj Rajaratnam himself. The writer urged him not to buy video-conferencing firm Polycom Inc.’s stock “till I get guidance; want to make sure guidance OK.”

The cryptic note was sent by Roomy Khan, a former Intel Corp. employee whom authorities had suspected in the past of sending inside information to Mr. Rajaratnam. People familiar with the matter say those few words hidden among millions of others proved a turning point in what would become the biggest insider-trading case in two decades.

By November 2007, Ms. Khan, confronted with the text message, agreed to cooperate and record her phone calls with the hedge-fund tycoon…

Ms. Khan — who has since pleaded guilty to conspiracy, insider trading and obstruction of justice in connection the Polycom, Hilton and Google trades — agreed to record phone calls between her and Mr. Rajaratnam. Before Ms. Khan dialed him on Jan. 14, 2008, FBI agent B.J. Kang walked her through how she should quiz her old friend.

“What’s going on with earnings this season? Are you getting anything on Intel?” she asked, according to a person familiar with the situation. Mr. Rajaratnam answered that Intel’s revenue would be up 9% to 10% and that profit margins would be “good,” according to the person.

Mr. Rajaratnam was right: The next day, Intel reported revenue up 10.5% for the period and profit margins above the company’s earlier prediction.

That was enough for prosecutors. Using evidence from the Intel call and other recordings Ms. Khan made, they asked a Manhattan federal judge in March for permission to eavesdrop on Mr. Rajaratnam’s phone calls.

We have two seemingly smoking guns here. The first is a text message from a hedge fund consultant saying that she was looking to get guidance on Polycom earnings; the second is a phone call with Raj Rajaratnam himself in which he was reasonably good at guessing what Intel’s earnings were going to look like.

Isn’t this what stock-picking hedge funds like Galleon do? They try to anticipate corporate earnings — that’s their job. And while it’s always possible that people who are right about earnings are right because they have inside information, there are lots of other possibilities too. After all, people who are right about earnings often don’t have inside information, and people who are wrong about earnings sometimes do.

But in both key cases here — the text message and the phone call — talk of upcoming earnings was taken as prima facie evidence of some kind of crime. In the first case, it sufficed to turn Roomy Khan into a government informant.

I feel there must be something I’m missing here — or is this really all that’s needed to persuade a judge to approve a wiretap?



The standard, if I recall correctly, is that there must be a fair probability that the wiretap will reveal evidence about a crime.

I think the government must have had some evidence not mentioned in order to flip Khan (unless she was in a position that made the impropriety of her communications obvious). However, even with what is mentioned, its more than enough to get a warrant.

I would imagine Khan’s testimony that there was an insider trading ring was the core of the request, and the evidence here was used to corroborate her story. (If I recall correctly, the unsupported testimony of a co-conspirator is generally not good enough to get a warrant).

The request may have gone something like this:

We have a witness who admits to being in an insider trading ring with Rajaratnam. She claims to have passed him information on Polycom. The text message corroborates that. She claims he had access to inside information from employees at Intel. This is corroborated by his uncannily accurate predictions. Repeat as needed for the other tapped phone calls and businesses he allegedly had information on.

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Felix Salmon
Dec 30, 2009 06:29 UTC

I’m enjoying Brad’s new book. But arguably he’s even better as a photographer — DeLong

The suggested user list makes a huge difference in number of followers, but no difference in retweets, replies, or clicks — Dashes

24 things that were true on this day in 1999 — Foreign Policy

Deep geopolitical thinking from Ben Stein: “They’re psychos, same as all terrorists and murderers”. (Forward to 6:30) — Politico

Nick Denton explains how he turned into “a goggle-eyed moron” after moving to NYC and starting to watch TV — PVRBlog

Nokia says most Apple products violate its patents — BBC

A wonderful Tierney column on delayed gratification — Tierney

Next Decade Will Be Good One for Stock Investors — Bloomberg

David Levine, RIP — NYT

Postrel is very good on the freelancer ethics dilemma facing the NYT — but doesn’t Tripsas also get speaking fees? — Dynamist

The changing landscape of the TV business

Felix Salmon
Dec 30, 2009 06:22 UTC

Andrew Vanacore has a long and sometimes confusing overview of the state of play in the television industry, which concentrates on the possibility that one or more networks might convert into cable channels sooner or later. But there seem to be lacunae in the story — not least the large number of cable channels which pay for the privilege of being featured in the cable-TV lineup, rather than being paid by the cable companies.

Also missing is any indication of the effects of the move to digital broadcasting. Reader William Wang notes that this vastly increases both the quantity and the quality of free-to-air television stations, which, combined with Hulu and Boxee and YouTube and all the other free sources of TV, should put a lot of pressure on cable companies who have historically had local monopolies and the ability to raise their prices every year with impunity.

The networks are increasingly fighting with the cable operators, now that the likes of Rupert Murdoch have decided that network TV, just like newspapers, is something which should have more than one revenue stream. Now free-to-air digital broadcast TV does not, of, course, come with any kind of monthly subscription stream from a cable operator desperate to still be able to serve up American Idol to its loyal customers. But the networks still reach vastly more viewers than any cable channel, and so if they started adding their in-house cable channels, like Fox News, to the digital broadcast spectrum, they might be able to get a significant bump in viewership.

I still think that by far the best outcome for most constituencies would be a la carte pricing, where viewers — rather than cable companies — decide what’s worth paying for. Every television station on cable could then charge as much as it liked, with an eye to maximizing the sum of subscription revenues and advertising revenues. But what’s clear is that we’re moving to a world where the number of options is multiplying, and corporate strategy is going to get extremely complex extremely quickly.

The latest round of fights between producers and distributors smells like the dying gasp of a 20th-century TV business model to me, with essentially only two sides in the game. The consumer is left out in the cold, shivering as cable bills rise much faster than inflation. Pretty soon, the consumer is going to have a lot more power, and that’s going to change the game in profound and fundamental ways.


This is irrelevant to the content above, but I’m hopeful someone can answer my question. I’m doing a theoretical business plan for a school project over starting a cable network. Can anyone tell me the distribution process the company has to go through in order to air?

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Don’t trust those servicers

Felix Salmon
Dec 30, 2009 03:28 UTC

Michael Powell has real-world examples of why it’s really just better to walk away than it is to try to deal with evil and/or incompetent mortgage servicers:

Aurora, which has a $116 billion loan portfolio, was a subsidiary of Lehman Brothers before that firm went bankrupt…

Tom Vellucci, 54, is one of the four plaintiffs in the lawsuit, and a soldier in this army of the potentially dispossessed. Once a maintenance man for an insurance company, with a modest home in Floral Park, Queens, he lost his health and then his job. When a tenant stopped paying rent, he fell behind on his mortgage. A so-called rescue firm offered to negotiate better terms and wheedled Mr. Vellucci and his wife, Maria, out of $8,000 in fees.

When the inevitable foreclosure notice arrived in March, the Velluccis called Aurora Loan Services and asked for a break. The company, he said, responded by piling on legal fees and giving them a four-month trial agreement that did not reduce their monthly payment.

The Velluccis say they drained their savings making payments. Then the couple asked Aurora if they could revise their mortgage terms under the Obama rescue plan. They say the company refused, saying their mortgage was not eligible because it was owned by investors.

Aurora makes a similar statement about investor-owned mortgages on its Web site. These claims are not true. The Obama program requires companies to make an effort to modify such mortgages.

Sitting on a bench in the Queens courthouse, where he has become a regular, Mr. Vellucci ran his fingers through thick black hair and shook his head. “We kept trying to pay on faith, all faith, so we could prove we were honest people,” he said. “Now all we look like is stupid.”

I can’t find the statement on the Aurora website, but I don’t doubt that it’s been as obstructionist as it possibly can be:

Leonard N. Florio, a court-appointed referee, oversees such sessions in that dusty room in Queens. He is a chatty man and punctilious about not taking sides. But as he watched Mr. Ali, the Ozone Park homeowner, load his piles of bills and receipts back into his shopping bags, he could not help noting a pattern.

“I have yet to see an attorney for a servicer cut a deal,” he said. “Update this, update that. I mean, what’s the holdup?”

What we’re seeing here is the mortgage equivalent of credit-card sweatboxes: servicers who make sure to drain homeowners’ savings before they foreclose, since they know that they won’t chase homeowners after foreclosure, even in recourse states. By holding out the promise of a modification tomorrow, they make sure to squeeze every ounce of blood out of the homeowner before finally snatching the home away anyway.

So this is what I’d like to ask Megan McArdle, and others who like to extoll the moral virtues of paying one’s debts: just how much of your life’s savings should you give these snakes before they take your house?


I agree with the first post.

But it’s illustrative of how far “morality” has declined that we no longer think the borrower has an obligation to service the debt! Walking away and handing the house to the bank is acceptable.

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Changing banks

Felix Salmon
Dec 30, 2009 00:28 UTC

Should people move their money from the big four commercial banks to smaller community banks? Arianna Huffington is making a big push, but I’ll believe it when I see it: moving banks is hard, and people are lazy.

The one thing I would urge though is that if you are moving your money out of BofA/Chase/Citi/Wells, that you strongly consider not only smaller banks but also local credit unions as a place to move your money to. The moveyourmoney.info website is happy to give me a list of local banks including Mitsubishi UFJ (no one’s idea of a small community bank), but doesn’t list any credit unions at all. Here’s a tool to help you find one. If you’re going to go to the hassle of switching away from the big banks, then at least make sure you’ve explored all the options.


Thanks, Felix, for taking note of credit unions. As not-for-profit co-ops, their rates are generally better and fees lower than banks of all stripes. Good to see that a number of commenters are making this point on the Huffington Post site as well. There are DataTrac daily bank vs credit union average rate comparisons and a credit union locator tool, the most comprehensive in the industry actually, at http://www.creditunion.coop (click on “locate a credit union”).

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Inside the legislative sausage factory, banking committee edition

Felix Salmon
Dec 29, 2009 22:34 UTC

Ryan Grim and Arthur Delaney have the must-read story of the day, on the politics of the House financial services committee. It’s long — 6,500 words, spread over three pages — and it took five journalists in all to piece it all together: don’t say that HuffPo doesn’t do original reporting!

Do read the whole thing, but in a nutshell, the problem is that the committee is far too big, weighing in with 71 members: when was the last time that you ever saw a 71-member committee which ever got anything done. To make matters worse, a large proportion of those 71 members are conservative Democrats in marginal seats facing Republican opponents. They want to be on the committee because it’s an easy way to monster campaign donations, with freshmen representatives raising over $1 million apiece if they sit on the committee. That’s twice as much as if they don’t. And once they’re on the committee, they tend to be pretty friendly to Wall Street and its lobbyists.

And with so many members, you can imagine the number of revolving doors there are:

Just as the lure of money leads inexperienced new members to join the committee, it prompts experienced staffers to bolt for larger paydays in the private sector. “You have this phenomenon where if you have a staffer who’s very experienced on a certain issue and is dealing with the financial sector for any number of months or years, all of a sudden they become a real acquisition target for Wall Street,” says Lynch.

According to a HuffPost analysis of the 243 people who’ve worked on the committee — including clerical and technology staff — since 2000, almost half of the 126 people who have left registered as lobbyists, mostly for the financial services industry…

And the revolving door turns in both directions. Sixteen of the committee’s 86 current staffers — including a good chunk of the senior staff — worked as lobbyists before coming to the committee. (And it’s not just Republicans; 12 of the 16 are Democrats.)

The only real hope for the committee is Barney Frank himself:

Ultimately, though, Democrats are essentially relying on a “great man” strategy, figuring they can dump as many bank-friendly Democrats on the committee as they want and Frank will generally keep them in line. “We have a lot of faith in Barney. He can handle it,” says a senior Democratic aide when asked about the phenomenon. Frank’s senior staffers, say several current and former committee aides, similarly outmatch their counterparts. The chairman, they say, is able to use the knowledge gap at both the member and the staff level to his advantage.

The problem, of course, is that there are limits to Frank’s power, and that if there are good political reasons to vote one way, then no amount of detail-mastery among Frank’s staffers is likely to change your mind.

Meanwhile, there’s strong empirical evidence that the sheer force of any given financial institution’s lobbying power is directly related to the riskiness of its lending operations. The IMF’s Deniz Igan, Prachi Mishra, and Thierry Tressel report:

Our findings indicate that lobbying is associated ex-ante with more risk-taking and ex-post with worse performance. They are consistent with a moral hazard interpretation whereby lenders engage in risky lending strategies because they expect preferential treatment associated with lobbying. Such preferential treatment could be a higher probability of being bailed out, potentially under less stringent conditions, in the event of a financial crisis.

There’s no way to fix this broken system before financial regulatory reform has come and gone as an issue before Congress. Which is one more reason to be pessimistic about the likelihood of necessary root-and-branch changes ever happening.


Question is why is there Committee of 71 members? Which other committees have similar problems?

Are you saying there is no way in the world we can have new committee structure unless Banking Regulations are passed? How about new Congress say after 2010 election? Clearly that will be late, but if that new Congress can bring the committee of lesser number of people; is it not worth for American people to wait till then?

Considering the enormous importance of these Committees who right legislation in this country, why are people’s vote stopping only at electing these members? Why are People not having right to decide which committee’s, what is their jurisdiction and their composition? Are these Committee details enshrined in Constitution? Or is it something along the lines of Filibuster of Senate what people have made as after thought (naturally at the great of American voters)?

The reason we need to start asking these question, start demanding our representatives for such procedural reforms is for too long we Americans have been away from the machinations in the Congress. These Congress folks need to be transparent to us and we no longer can or should take anything for granted here.

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Is 3G wireless doomed in cities?

Felix Salmon
Dec 29, 2009 16:37 UTC

Is AT&T’s inability to provide decent wireless broadband in tech-savvy cities like New York and San Francisco a simple matter of physics? Phorgy says yes:

At low frequencies, radio waves are kind of like molasses. They can ooze around corners and through buildings…

As frequencies increase, the waves start acting more like laser beams. They no longer ooze around corners. You start to get “shadows” or dead spots with no signal. It becomes more difficult for the signals to penetrate walls etc. These problems get worse the higher you go in frequency…

So we have two extremes: low frequency molasses waves and high frequency laser beams. As bandwidth demands increase, we begin moving the dial away from molasses (where we have good wireless signals) to laser beams (where we have dark spots, shadows, with no signal, etc).

There are many clever modulation tricks that delay the inevitable, but the basic rule is that you cannot defeat Heisenberg.

The fundamental insight here is true: smartphones operate at very high frequencies, sometimes above 2.5 GHz. And covering a city with wireless broadband at those frequencies is hard. But after a brief email exchange with Ultimi Barbarorum’s Baruch, who knows much more about this kind of thing than I do, I’m far from convinced that what we’re seeing right now with AT&T has anything to do with the hard physical limits that Phorgy is talking about.

For one thing, Phorgy’s limit of 1,000mps in total for a few city blocks is I think far higher than anything AT&T is currently able to provide. With what Baruch calls “compression, prioritisation, all that level 4-7 stuff you can do at the packet level” (don’t ask me), you can serve a lot of people with that kind of bandwidth.

But more to the point, we already have a real-world counterexample which pretty much disproves any thesis that AT&T is bumping up against Heisenbergian limits. Phorgy’s saying that the problem with New York and San Francisco is that (a) they are very high density, complete with skyscraper canyons and the like; and (b) they have lots of people all trying to use 3G cellphones at once. But there’s a city with even higher density than either of those two, with even more people using 3G cellphones, and which has no signal-quality problems at all.

Tokyo is proof positive that this can be done.

The bottleneck is money, not Heisenberg. Building a Japan-style 3G network is extremely expensive: it involves lots of high-frequency and low-frequency base stations and base station relays and femtocells and backhaul capacity and IT investment and other things I don’t pretend to understand.

And of course this kind of investment doesn’t scale. If AT&T puts enormous of money into solving the problems of New York and San Francisco, they can use similar techniques in, um, Chicago. But nowhere else in the US has that kind of density — in contrast to Japan, where density issues are endemic.

If I were an AT&T shareholder, then, I’m not sure how much money I’d want my company to spend on beefing up 3G wireless in New York and San Francisco, especially when there’s little obvious return on such an enormous investment. Sometimes you make more money with cheaper unhappy customers than with more expensive happy customers. And this could well be one of those times.

Update: Some good comments, especially from Mark. Meanwhile, Paul Krugman asks whether central Tokyo might not be such a great counterexample after all: is it maybe less dense than Manhattan? Probably depends on how you define the two areas. But there are other cities which serve just as well: Hong Kong, for example.


I live in San Francisco and had wonderful service until AT&T updated the firmware. Now I want to switch ASAP. As mentioned by others; This is not a technical issue but a quality of service, or lack thereof, issue. Admittedly I don’t live/work among the dozen or so highrizes in the city, but the majority of SF users probably spent half there time in siliconvally or the “suburbs” were the service is just as bad.

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