Imagine a betting window at the racetrack where you can bet any amount that a horse will not win, as opposed to the usual bet on a horse to win. You can make these bets at 30 to 1 odds every time – and you can get all your friends to join in so that your bets go up into astronomical amounts of money.
And, you can make as many bets as you want – with 7 or 8 horse in the race, it is way easier to pick the loser than to pick the one and only winner – so this helps you sell and re-sell these bets, on which, I almost forgot to mention, you are making huge profits and you are telling everybody who will listen that these are virtually risk-free bets. You can bet more money than you have in your bank account and even more money than all of us have in all of our bank accounts, combined.
And then you can keep selling and re-selling those bets on horses to lose, not win, mind you, all over the world – give them fancy French names like “tranches,” or formidable sounding names like “collateralized debt obligations,” (we’ll call them “CDO’s, for short here), including “credit default swaps.”
And people all over the world buy them up like the proverbial hotcakes – after all, they are risk-free; a true no-brainer. But, best of all, there is no regulation at all, whatsoever – nobody is watching! The Foxes truly rule the Henhouse (with apologies to Joel!). Here comes wealth beyond dreams of avarice!
Sound ridiculous? Pretty absurd to imagine that people can make bets with money that they could not hope to repay, on losers, not winners – more money than any one country even has, maybe more money than the entire world’s GNP? Welcome to the Through the Looking Glass World of CDO’s, those stinking time bombs that, to this day, we simply do not know just how bad the stench coming from the balance sheets of many financial institutions will total up to be, financial institutions that continue to play poker with these exotic financial instruments as I write this.
Last week, in Media coverage immediately swallowed up by stories of Republicans dueling with Democrats, and vice versa, over torture and what Nancy knew and when she knew it, President Obama unveiled a bold and long overdue plan to regulate these ‘financial weapons of mass destruction,’ as the Oracle of Omaha famously called them years before they blew up and dragged down the world’s economies into the muck we are now in.
Astonishingly, up to now, these virtually incomprehensibly complex, but amazingly profitable, exotic financial instruments were regulated, virtually in name only, by the absurdly, thinly-staffed regulatory agency that oversees Thrifts (S&L’s)– who was not ready for prime time and simply not up to the job – just the way the Players in those markets wanted it, I surmise.
Last week, Treasury Secretary Geithner explained the new plan to bring rationality to the world of exotic financial instruments and CDO’s – those crazy bets I was describing at the beginning of this piece – and to further require that CDO’s can only be traded on exchanges staffed by sufficient numbers of qualified people who can and will oversee and control the incredible harm that these things can do, if left on their own in their shadow world where they did not even appear on some balance sheets. AIG was nearly brought down by them; other giant financial institutions were severely crippled as well.
Oh yes, this plan will require that trading in these exotic financial instruments must also be backed by actual capital reserves – no more 30:1 bets that in amounts that you could never repay in a million years! Amazingly, there has been so such requirement before this – you literally could bet what became a Daisy Chain, running up into the Trillions of dollars – some have estimated that there are between $50 and $65 Trillion dollars worth of troubled CDO’s out there; some say in the hundreds of Trillions; nobody really knows – more than all the money that the world handles; significantly more. That’s Trillion, with a ‘T.’
Under the new, proposed regulation of the CDO market, you will now only be able to bet some rational multiple of what you actually have in capital reserves, to back up your bet, so that you cannot literally ‘bet the farm’ on a “risk-free” investment (there is no such thing, but, that’s how these were marketed for much of this decade!), which proved, when the housing market utterly collapsed, to be anything but ‘risk-free.’ This proposed new plan, if not watered down into oblivion by the financial institutions’ lobbyists (remember, these exotic financial instruments were so profitable that they were like a license to print money), would bring some much-needed transparency to what had been a completely off-the-radar investment world that came close to destroying the world’s financial systems last Fall.
What the plan does not include, however, is a good injection of plain, common sense about investing. There are no risk-free investments; if someone tries to sell you one, run, don’t walk, in the other direction. If something is too complicated for the person selling it to be able to explain it, don’t buy it – particularly if you are investing OPM (other people’s money) like pension plans, municipalities’ funds and the like. CDO’s were off-the-charts complex – the old expression that you had to be a “Philadelphia lawyer” to understand a legal document, doesn’t even come close to what these CDO’s were about.
To understand those exotic financial instruments you had to be a combination of Stephen Hawking and Warren Buffett, and when the latter warned us about them, nobody listened because the lure of fat profits and big bonuses seduced them out of rationality to line up at the betting window.
Let’s just hope that meaningful regulation finally puts this monster back into Pandora’s Box, because we have a nasty track record of forgetting these simple things.