A loss so big, it seems "synthetic"

Anyone remember the big Soviet demonstrations of military might on May Day? It used to be that every year on May 1st, the Soviets would unveil the power of all their many weapons by parading samples of them down some expansive street in Moscow. Grim soldiers would walk in precise steps past the aged members of the Politburo. It was indeed an impressive display of strength, impressive enough to foster "the arms race."

Moscow's May Day is, of course, ancient history, taking place back when our only enemy, it seemed, was communism.

Today, we face various dangerous enemies on many fronts. And in a story with a May 1st dateline, the Wall Street Journal gives us a glimpse into a mighty enemy that today threatens the United States. You can find the description of this enemy in the story they call "Number of the Week."

This is one of the enemies we face today:

"$132 billion."

That's the dollar amount of the total losses generated by synthetic mezzanine ABS CDOs. These are the innovative financial instruments created and sold by firms like Goldman Sachs, Merrill Lynch, Morgan Stanley and other big players in the financial sector. They're the kind of tools the helped drag our economy off the cliff in September 2008.

That's why that number is an enemy. It represents the terrible business practices that have inflicted serious wounds to our economy. "$132 billion" in losses. I look at that number and marvel at its impressive size. And then I wonder what the hell a "synthetic mezzanine ABS CDO" is.

Here's what the WSJ has to say:

"The names of the deals serve only to obscure their true nature, so we’ll just call them a betting game. This game allowed investors — including banks and insurance companies such as UBS, Merrill Lynch, AIG and Germany’s IKB — to make huge side bets on the performance of subprime borrowers, dramatically increasing the amount of money that would have to change hands if things went wrong."

Still hazy on what these "synthetic mezzanine CDOs are. So hazy that I wonder why our federal government had to bail out banks in order to rescue them from the consequences of a "betting game."

So I googled "mezzanine ABS CDOs" and got 94,100 links.

Time crunched as I am, I went to Wiki Answers first. Here's their description:

"A CDO is a collateralized debt obligation, a security whose principal and interest are repaid by the cash flows generated by a portfolio of assets (usually loans and bonds). The portfolio of assets is the collateral and it is usually in the balance sheet of a separate entity, called special purpose vehicle, which has the CDO as its only liability and the assets in the portfolio as its only assets. ABS CDO is a CDO whose portfolio is comprised of ABS (asset backed securities). A CDO is subject to credit risk, because some of the assets in the portfolio might not generate the expected cash flows (when the underlying credits go into default). Often, the CDO is tranched in tranches of different seniority, which have different priority in absorbing the eventual losses. The equity tranche, the less senior, absorbs the first losses (if there are any). Then comes the mezzanine. Finally come the senior tranches."

All clear now? Not really. In my attempt to translate that info into English, it seems that CDOs are instruments that are supposed to have cash flowing into them - "generated by a portfolio of assets (usually loans and bonds.)"

Sounds great! I like investing in instruments that create a return on my investment!

Who knows if Wiki Answers is right! But where else would I turn for this info? Websites of our strong and successful financial firms? The ones who assure us that "synthetic CDOs" are innovative tools we need to make America strong? No thanks!

But the Wiki Answer is describing "mezzanine CDOs." What about "synthetic mezzanine CDOs?"

Apparently, it's an instrument created out of the fumes of a real CDO. As Gertrude Stein once said of Oakland, "there's no there there" in synthetic CDOs.

Well then! Perhaps that's a reason why they contributed to such a massive loss?

From the WSJ "Number of the Week" story:

"It’s as if our entire financial system went to the racetrack and put a big chunk of its money on a single horse."

Sounds like the investment banks who like to brag about their focus on customers lost sight of the customer. Betting "big chunks of money" on single horse is a terrible methodology for "risk management." (Though it worked well for that guy who bet $100K on Super Saver at the Derby this year!)

Risk management's a key job for our financial sector. Isn't it? Or have they transformed into Vegas gamblers, with the generous backing of the US government as the key differentiator between success and bankruptcy?

That's why this figure - this $132 billion in losses from synthetic CDOs - is such an enemy. It represents massive failure on many fronts.

The economy has been gutted; the government, under George Bush and Henry Paulson, bailed out the financial sector; unemployment soared, as did federal debt, as did profits for the financial firms that were rescued.

It's an equation for continued disaster, frankly. We cannot afford to bail out the banks any more. The socialization of loss and privatization of profit is a terrible model of capitalism.

If this is the kind of innovation our financial sector is peddling, it is as dangerous to the United States as the Soviet tanks and bombs that were once paraded through Moscow on May 1st.

What is our financial sector doing about this? Claiming that their work (God's work!) was done right. Here's what Lloyd Blankfein, CEO of Goldman Sachs, said the other day in his prepared statement to Congress:

"Much has been said about the supposedly massive short Goldman Sachs had on the U.S. housing market. The fact is we were not consistently or significantly net “short the market” in residential mortgage-related products in 2007 and 2008. Our performance in our residential mortgage-related business confirms this.

During the two years of the financial crisis, while profitable overall, Goldman Sachs lost approximately $1.2 billion from our activities in the residential housing market.

We didn’t have a massive short against the housing market and we certainly did not bet against our clients. Rather, we believe that we managed our risk as our shareholders and our regulators would expect."

No regrets coming out of Goldman Sachs! In losing $1.2 billion dollars in the housing market for their own firm, in creating an instrument - this synthetic CDO that gained John Paulson (no relation to Henry) a billion bucks and lost IKB the same amount - Goldman Sachs, according to its leader, "managed our risk as our shareholders and our regulators would expect."

Actually, Blankfein is wrong. In America, we expect far better of the number one investment bank in the country. And we deserve a financial sector that is held accountable for its business decisions, not bailed out and rescued when they fail.