April 21, 2010

Thanks to Larry Summers, Goldman Will Get Off With Hand Slap

Filed under: Uncategorized — ktetaichinh @ 7:44 pm
Tags: , , , ,

Tom Armisteed provided the final bit of the jigsaw puzzle.

The Scoop is that Larry Summers was the person who made sure that Credit Default Swaps (CDS) were not “classified” as insurance, so they were not subject to the same regulation as a normal insurance product.

In answer to a question, “Reference?” Tom provided this:

Here is a link (.pdf) to the relevant testimony:

So at the same time, in 2000, the New York Insurance Department was asked a very carefully crafted question. “Does a credit default swap transaction, wherein the seller will make payment to the buyer upon the happening of a negative credit event and such payment is not dependent upon the buyer having suffered a loss, constitute a contract of insurance under the insurance law?

Clearly, the question was framed to ask only about naked credit default swaps. Under the facts we were given, the swap was not insurance, because the buyer had no material interest and the filing of claim does not require a loss. But the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the Department’s opinion on a subset of credit default swaps as a ruling on all swaps.

What’s hilarious about that (I mean I was rolling on the floor laughing for at least five minutes, I almost died), is what Summers “proved” was that the way to tell if something is “insurance” or “not insurance” is whether the potential claimant (if for example the house burns down) has an insurable interest or not.


So this is how it works:

1: If you insure your own house against burning down, then that is “insurance:.

2: If you insure your neighbours’ house against burning down (ie, you get paid if it does), that’s not “insurance”

Therefore a CDS is not insurance…QED.

That’s why you can (lawfully):

A: Take out a bet that you neighbours’ house will burn down, burn it down, and then claim on the CDS, and even if you get caught in the act of burning down the house, you still get paid the CDS (although you might face other charges).

B: Take out a bet on your neighbours’ house burning down if you notice that it is starting to burn down (but the CDS issuer didn’t).

C: Not disclose anything to the CDS issuer about what you know about setting fire to houses, or noticing they are burning down.

And all that is because a CDS is NOT insurance…it’s something else.

It’s like some weird gambling game – played in the back-streets, without any regulation.

If a CDS had been insurance then in the words of Tom Armisteed:

(According to) the old legal doctrine: uberrimae fidei. Briefly, it’s a Latin term, translated as “of the utmost good faith.” A contract is said to be uberrimae fidei when it requires a high standard of honesty – unprompted disclosure of all material facts: absent good faith at this level, it is voidable.

What that says is that if Goldman (GS) had not disclosed everything to the buyers of the “long-end-of-the-stick” that they could have possibly needed to know in order to make a rational and informed decision, then the “insurance” would have been voidable.

Like a “pre-existing condition”.

Which would have meant that Goldman would have STILL had to pay the $845 million to Paulson that they did (I suspect they wrote the CDS in question months, perhaps a year or more, before April 2007).

BUT, this is the thing; the “Long-end-of-the-stick” would not have had to pay Goldman the $1 billion. Or if they had done that by mistake, Goldman would have to pay them back…He-He.

But that is not what the LAW says, according to the LAW they were obliged to provide all of the information in existence for the “dumber than thou” to examine, but not any information on the circumstances of the deal.

Although as Garry Greenberg explains so well, that wouldn’t have done them any good because it is basically impossible for someone on the “buy” side to figure out if an RMBS is any good based on the information that used to be (and still is) made available.

That’s because of a number of things, which include the fact that the “documentation” on the RMBS that backed up the CDO in question would have weighed about half a ton.

And you would had to have been a savant to read through all that in the time (like Michael Burry did. He was the guy who really cracked the game…Paulson just learned the tricks from him, and managed to get more money deployed).

Oh yes I forgot, the “independent” expert that the buy-side insisted on, was (a) not much of an expert, but although Goldman paid them, Goldman were not liable for their performance or competence, just as they were not liable for the competence of the ratings agency that stamped AAA on the RMBS in question.

And (b) they were under no legal obligation to tell the “punters” that their “expert” was doing the things that Tiger Woods was accused of doing with pretty young girls to whom he (allegedly) paid $15,000 a session.

That’s according to Karl Denninger.

Of course, the SEC will have to prove that “information” was exchanged along with the body-fluids.

If not, well, thanks to the sterling efforts of Larry Summers in “Making America Safe” and proving that a CDS was NOT insurance and was simply an “innocent” bet between two consenting adults, Goldman will probably get off with a warning to not allow their staff to exchange body fluids with the hired help.

And that will be that.

Interesting that there is nothing in the 1,300 pages of Financial Reform that says anything about treating a CDS as insurance (and regulating it as such) or requiring uberrimae fidei.

Disclosure: No positions


About the author: Andrew Butter
Andrew Butter picture

Born and grew-up in Kenya, early career as a scientist/engineer. Set up a market research company in Dubai in 1990 – interested in what makes some countries work, and why some don’t, major client was Dubai Government. Joined Arthur Andersen as an investment analyst in 1995 later worked for Moore.


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