Point #1: Agents in a marketplace first commit to a trade, and then exchange the property rights they committed to trade. The financial jargon for the mechanism which permits this exchange of property rights is "clearing and settlement".
Point #2: In the USA there is much slop in these "clearing and settlement" mechanisms. Processes that you would expect to be one-to-one, or fixed-number-to-one, are actually sponge-to-one. People who understand this slop can loot the system knowing that it will not be discovered for a long time (and not in the ruins, if it comes to that). Unfortunately, their activity leaves behind a residue that is a form of financial derivative, which in large quantities poses systemic risk.[1]
Point #3: In the last two years this issue has been the common denominator underlying scandals involving stocks,[2] Mortgage Backed Securities (MBS),[3] Credit Default Swaps (CDS's),[4] commodities,[5] and Exchanged Traded Funds (ETF's).[6]
Point #4: The line between Organized Crime and the financial community has grown fuzzy.[7] In particular, clearing and settlement is all mobbed-up, and wherever one pokes into it one quickly comes upon Bad Boys and Bad Boy Firms.
Point #5: You hope that financial regulators and journalists are protecting you from things like this, but they are not. Why not? Some have been co-opted intellectually: Our financial intelligentsia holds an inappropriately fervent commitment to the Efficient Market Hypothesis, and this leads them to overlook the ways that slop in the system is pernicious (even if is fungible slop).[8] Some lack the horsepower to follow along.[9] And some, like Jim Cramer, are dirty.[10]
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[1] As Warren Buffett's partner Charlie Munger put it, "Those delays in delivering sometimes reflect tremendous slop in the clearance process. It is not good for a civilization to have huge slop. Sort of like how it isn't good to have a lot of slop in nuclear power plants." Berkshire Hathaway Annual Shareholders' meeting, May 2007.
[2] "SEC Extends Naked Short-Sale Order on Fannie, Freddie" ("The U.S. Securities and Exchange Commission extended an emergency limit on short sales in shares of Freddie Mac, Fannie Mae and 17 brokerages as it prepares broader rules to thwart stock manipulation"), Bloomberg, July 29, 2008. "Naked Short-Selling Blamed in Wall St Crisis" Associated Press, 9/16/2008.
[3] In "The End of Wall Street" (Portfolio Magazine, November 2008) Michael Lewis wrote:
""That's when Eisman finally got it. Here he'd been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. The firms used Eisman's bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn't create a second Peyton Manning to inflate the league's stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. 'They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford,' Eisman says. 'They were creating them out of whole cloth. One hundred times over! That's why the losses are so much greater than the loans. But that's when I realized they needed us to keep the machine running. I was like, This is allowed?'"
For an explanation of how this ties in to the ongoing foreclosure crisis, see "Foreclosure Crisis: Punchline to a Michael Lewis Joke from 2008?" (Deep Capture, October 18, 2010). For an explanation of the systemic stakes, see "The Real Danger From the Foreclosure Crisis", Zerohedge, 10/15/2010.
[4] "Regulation: EU Comes Out Against Naked CDS Shorting", Euromoney Magazine, March, 2010. Regarding the claim that naked shorting of CDS is a benign activity, "Richard Portes, professor of economics at the London Business School, says that's a nonsense. He uses the example of the 1992 sterling crisis, when George Soros bet around $10 billion against sterling, which most observers believe significantly affected the market and the outcome, even though daily trading volumes at the time were $100 billion. As Portes sees it, naked CDS as a speculative instrument might be a key link in a vicious chain that eventually could lead to a run on a sovereign's credit quality."
[5] "Silver Market Probe: Act Now, CFTC Is Urged", Wall Street Journal, October 27, 2010. "The CFTC's investigation of silver has heated up in recent weeks. The agency's enforcement staff has circulated a packet of information to CFTC lawyers and commissioners, outlining some of its findings in the silver probe, including documents that could suggest there have been attempts to manipulate prices."
[6] "New Report Outlines Causes of Market Distortions Choking Recovery and Preventing New Growth Companies from Going Public: Derivatives known as 'ETFs' are the true culprits in artificially setting stock prices and posing threats to market stability", Kaufman Foundation, November 8, 2010. "New Report Blasts ETF's For Systemic Risk" CNBC, November 8 2010. "Can Naked Shorts Collapse an ETF?", Barron's, December 7, 2010.
[7] See FBI Operation Uptick: "In what authorities are calling the largest securities-fraud bust in U.S. history, 120 defendants — including members of all five New York City Mafia crime families and the treasurer of New York City's police-detectives pension fund — were indicted Wednesday…" CNN, June 14, 2000. For a more recent investigation into how Organized Crime has become entwined in our market, see "Michael Milken, 60,000 Deaths, and the Story of Dendreon", DeepCapture, July 2009.
[8] For explanation, see "The Deep Capture Analysis: Systemic Risk".
[9] See for example "Anti-Investigative Reporter Joe Nocera and the Newspaper of Non-Record (New York Times)".
[10] See Jon Stewart's magisterial public dismemberment of Jim Cramer at "Daily Show: Jim Cramer Extended Interview Parts 1, 2 and 3". For fuller background, see "Deep Capture: Jim Cramer is a Complicated Man".
