Opinion

Felix Salmon

Fixing information asymmetries

By Felix Salmon
July 2, 2010

In the wake of my blog entry yesterday about the way in which Goldman’s interaction with AIG helped to exacerbate the financial crisis, I got a very interesting email from a former Goldman employee:

Insofar as the law is never going to be perfect, it’s certainly good that we are nice to our neighbors even when the law doesn’t require it, but when you find yourself saying, “Yes, this action was legal and within the rights of the agent, but helped precipitate great social harm,” you’re looking at a good candidate for a change in institutions, and legal institutions, for all their shortcomings, are the easiest ones to change. Ratings-based collateral deals might be a good target for regulation; the big liquidity hit that a credit downgrade can cause feels like exactly the sort of creditor-run that bankruptcy is supposed to prevent.

I like the idea that contracts concerning collateral should not reference credit ratings. In general, the less standing that credit ratings have, both legally and in private bilateral contracts, the better. They’re invidious things: no one should use a triple-A rating as a business model (see GE and the monolines), and a ratings downgrade in and of itself shouldn’t be able to precipitate a liquidity crisis: such things should never be self-fulfilling, since that just introduces needless systemic dangers into the financial architecture.

The former Goldman employee continues:

Should I have tried to call Treasury/SEC/some NY insurance regulator when it was obvious from our standpoint that AIG had no idea how much trouble it was in? When reminded of my duties to Goldman clients I basically translated that in my head to “Don’t short AIG.”

If Goldman employees reckoned that shorting AIG was a breach of corporate ethics, it’s hard to justify the fact that Goldman was happily shorting AIG for its own account.

As for the first question, back in October, Lloyd Blankfein said that Goldman should have been in more contact with regulators. But he seemed to put the onus on the regulators, rather than the banks:

We have to build a culture whereby firms are required to share concerns about systemic risks with regulators…

Regulators could establish a multi-firm business practices committee to examine issues such as underwriting standards. If practices slip, regulators would be among the first to know. They should ask questions such as: “Where are policies being stretched and pressures building? Where are you seeing concentrations in risk, crowded trades or one-way bets?”

I worried at the time that there would be big conflicts between banks’ responsibility to share information with regulators, and their duty of confidentiality to their clients. But it’s also increasingly clear to me that it’s silly to expect regulators to know exactly what questions to ask. If any employee of any bank sees a systemic risk, that person should have the legal obligation to take their concerns to the systemic risk regulator.

More generally, the problem here is that Goldman makes money from knowing or seeing stuff that other people don’t know or don’t see. It saw problems in the housing market which AIG was oblivious about, and took advantage of the information asymmetry there to make money. That’s how markets work. At some point, however, it risked setting up a negative feedback loop in which AIG would lose so much money that it would get downgraded and then be forced to put up even more money and then be downgraded further, etc etc. And I think that regulators should be within their rights to tell banks not to put on systemically-dangerous trades. Bringing down a small hedge fund is OK. Bringing down AIG, by contrast, ultimately benefits no one. As Goldman is slowly finding out.

Comments
6 comments so far | RSS Comments RSS

After screwing entire countries…

http://tinyurl.com/254oevs

AIG’s doesn’t seem all that important really, more like what GS eats for dessert. Credit where credit’s due: regulation’s the least of what’s in store for the goons of Goldman, to do them justice.

Posted by HBC | Report as abusive
 

to me, there is one point to focus on with the whole GS – AIG situation, but it’s kinda subjective, and perhaps that’s why it’s often overlooked.

the whole “GS is a bad guy for demanding collateral from AIG” meme is nonsense – and i’m not suggesting that you’re arguing that, Felix. What is also nonsense is Blankfein’s claim that GS was fine if AIG went down, because GS was hedged, via collateral and CDS on AIG purchased from others. as we know, there is/was massive systemic interconnectedness between all the players in the system, and if the government hadn’t funneled money through AIG to GS, it’s a pretty vast presumption by Blankfein that they’d have just been able to collect from their other CDS counterparties on the payouts they’d be owed after AIG failed. THAT is the point people constantly seem to miss harping on, but it’s the most important one.

(in case it’s not clear, all i’m saying is that GS”s claim that it was hedged with respect to AIG is almost certainly total bullshit – even though on paper it may be true – in reality, the “hedge” would have failed.)

Posted by KidDynamite | Report as abusive
 

“More generally, the problem here is that Goldman makes money from knowing or seeing stuff that other people don’t know or don’t see”

Perfectly OK for Goldman to make money. WHAT IS NOT OK IS THE FED BAILING IT OUT WHEN IT WOULD HAVE GONE BANKRUPT!!

“It saw problems in the housing market which AIG was oblivious about, and took advantage of the information asymmetry there to make money. That’s how markets work.”

EXACTLY!!

AIG also should have gone … that is how markets work!! WHAT THE $@%$ IS THE FED DOING MEDDLING IN THE MARKETS.. ALLOW IT TO WORK .. THAT IS WHAT WE WANT .. YOU TAKE RISKS … YOU MAKE MONEY KEEP IT .. YOU LOSE BIG TIME YOU CLOSE SHOP AND GO AWAY!!

THE OBJECTION IS ON THE BAILING OUT OF GOLDMAN BY THE CONNIVING SCOUNDREL BEN BERNANKE

Posted by killben | Report as abusive
 

When your confidant writes of being reminded of his duties to Goldman clients, the asymmetry of those duties becomes instantly apparent. To some, GS had a greater duty than to others.

Doing God’s work translates into playing God? Goldman, we have a problem.

Posted by HBC | Report as abusive
 

Being able to see things before others, does that include conversations with the NYFED? Andrew Ross Sorkind had Fuld whimpering that the FED sees everything so they had to be clean when dealing with them. My goodness how blind can the CEO be when he cannot be aware of the REPO action going on each quarter? (Ken Lay anyone? ( Shultz!!!!)) Getting back to reality here, we are very close to Goldman undertaking insider trading. Are they really smarter (ie better at statistical modelling) or better at getting inside information (legally of course?)
The shame of it is that people like Buffet have stopped thinking for themselves (he stopped about 30 years ago)and rely upon others bringing them the deals. In other words, the whole idea of the market is informational asymmetry only so long as the market is perfect in that it clears. The market is made by a few people and that is the problem because therein becomes the flaw. Only a fool invests their money in the market because it is not designed to help them or to allocate money to the most profitable industries. The information asymetry makes the traders (whoops I meant bankers) rich, so long as they do not get to large of slice no one minds, but everyone knows it.

There are markets and listing processes that only a handful of firms have entry into and they have no intention or motive to share the wealth. In one sense, why should they? But in another, why continue with the claim that the market is efficient?

Posted by sgreillylives | Report as abusive
 

KidDynamite, I think more importantly than the narrow affect of CDSes is the general chaos there would have been in the market if suddenly none of those counterparties had CDS protection on their CDOs and suddenly had to to take that hit to their balance sheets whilst the money markets were frozen due to LEH bankruptcy.

From recollection, a significant portion of the hedging was short equity positions against AIG, which of course they are being demonised for now.

HBC, are you capable of posting links that are not clearly BS? If you had even a passing acquaintance with any of the markets you seem to pontificate on you’d know that in 2007-2008 the commodity markets were bubble due to massive stockpiling by a number of countries – Philipines in particular with regard to rice – and “green” legislation on ethanol based fuels which pushed out other crops at the time. But hey why bother with facts when you can blame Goldmans?

Posted by Danny_Black | Report as abusive
 

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