It’s not just Goldman, it’s a systemic thing, but their role in the collapse of AIG:

Goldman Sachs Group Inc. and Societe Generale SA extracted about $11.4 billion from American International Group Inc. before the insurer’s collapse as the firms demanded to hold cash against losses on mortgage-linked securities, according to regulatory filings.

The problem with credit default swaps is that unlike short selling, which only effects a share price (though naked shorts should be banned, and the ban enforced), credit default swaps (CDS) can have the effect of bankrupting a company in a matter of hours, and frequently the holders of these securities have no interest in the survival of the underlying assets.

Just look at an instrument called the reverse convertible.

James Kwak has a hard time wrapping his head around this until he realizes that it’s nothing more than a way for bankers and brokers to screw their customers.

It’s so corrupt that it boggles his mind:

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that’s the basic idea.)

The simplest thing to compare this to is just buying the stock. Compared to buying the stock, there are three outcomes:

The stock ends up below $80: In this case, the reverse convertible is slightly better, because you got the$10 in interest, which is probably more than the dividends you gave up.

The stock ends up between $80 and $110: Again, the reverse convertible is better, because you got $110 (your principal plus interest); it’s a little better if the stock ends up close to $110, a lot better if the stock ends up at $81.*

The stock ends up above $110: Here, you do anywhere from a little worse (if the stock ends at $111) to much, much, much worse (if the stock goes over $200).

And then he asks, with no small justification, “What the hell is the point of this product?”

This is why I think that a financial regime needs to be established with the idea that that which is not explicitly approved is prohibited, because the current regime, even under Obama’s updates, gives us this toxic waste.

The Wall Street Journal has the story of how a bunch of the large investment banks got burned investing in “sure fire” credit default swaps. (paid subscription required)

You get a copy of the article here.

This kind of crap is why naked credit default swaps should be banned.

This ain’t nothing but a bunco game, straight out of the Mel Brooks movie, and Broadway musical, The Producers.

Some quotes from the article, and my comments:

The trade, by Amherst Holdings of Austin, Texas, was particularly galling to the big banks because it turned what they believed was a sure-fire profit into a loss.

(all emphasis in quotes mine)

If the profit is “sure fire” it means that someone is engaging in deceptive activity.

Privately held Amherst says it acted in good faith trying to limit losses for clients, who had sold credit-default swaps on the securities. “We wouldn’t jeopardize our business and reputation by entering into an opportunistic trade knowing what the outcome would be,” said Amherst’s chief executive, Sean Dobson.

This is a shot across the bow of the banks on the other side, since this is exactly what the big investment banks intended.

So far the latest dust-up has been all words, in part, bankers say, because they are wary of attracting more regulatory scrutiny at a time when lawmakers are planning major reforms in the largely unregulated derivatives markets, long lucrative for banks. While the banks’ combined losses from the trade were in the tens of millions of dollars — modest by recent standards — they are the buzz of Wall Street as firms try to prevent a repeat of the episode.

Ban naked CDS contracts, and it will not repeat.

Traders can buy credit-default swaps on securities they don’t own. At one point, at least $130 million of bets had been made on the performance of around $27 million in securities, according to a person familiar with the matter.

This is the part where credit default swaps, called a “naked” CDS in industry parlance, become a 3 card Monte game, and not insurance.

This kind of shit happens, and when things fall apart, you end up with AIG owing 40 or 50 times the value of the asset in insurance payouts.

This is why, 263 years ago, parliament passed the Marine Insurance Act of 1746, which required that anyone wanting an insurance payout demonstrate an interest in the continued existence of the property.

We have known for over 2½ centuries, since the South Sea Bubble, that this sort of insurance is dangerous and does nothing but create opportunities to game the system.

The frightening part here is that this scam is completely legal

Here is how it works:

1. Amherst Holdings sells credit default swaps on a bunch of bonds to J.P. Morgan Chase & Co.
2. Amherst Holdings sells credit default swaps on a bunch of bonds to Royal Amherst Holdings sells credit default swaps on a bunch of bonds to Bank of Scotland Group PLC
3. Amherst Holdings sells credit default swaps on a bunch of bonds to Goldman Sachs
4. Amherst Holdings sells credit default swaps on a bunch of bonds to UBS
5. Amherst Holdings sells credit default swaps on a bunch of Bank of America Corp.
6. Amherst Holdings sells credit default swaps on a bunch of bonds to a bunch of other banks
7. Premiums exceed the face value of the bonds by many times.
8. Amherst Holdings takes some of the premiums, and gives this to Aurora Loan Services with instructions to buy and retire the bonds.
9. The CDS contracts are now worthless, and Amherst Holdings has taken way more in premiums than it spent on the bonds.
10. Collect underpants.
11. Profit!

OK, it doesn’t actually involve underpants, but still.

The Congressional Oversight Panel (COP) chaired by Elizabeth Warren is saying that the stress tests were incomplete, too optimistic as to economic condistions, and too opaque

Opacity seems to be the Obama model on everything from the economy, to torture, to crimes by Bush and His Evil Minions^&trade.