Housing prices and securitization, and their collapses, are the central causes of the Great Recession, and the debate now rages over their deeper causes and, related and more forward-looking, how to reform the regulation of financial markets to avoid future meltdowns without killing the goose that lays the Goldman Eggs. The latest news is the extent to which plain old securities fraud seems to have played a role. The headlines have recently been grabbed by the SEC’s indictment of Goldman Sachs and their role in selling Abacus 2007-AC1 (e.g. here). This deal was for one billion dollars. This is a lot of money, but far short of the amount of the financial crisis. Remember, the total losses on sub-prime and alt-A mortgages in early 2008 given pretty bad scenarios were around 500 billion, an amount much smaller than that lost in the stock market decline following the internet boom in the 1990’s. The problem was the location of the debt instruments – hidden in banks and being held by all sorts of institutions that should have been holding only very safe assets. That and the cast that synthetic CDO’s seem to have been created with adverse selection in mind – picked to consist of the worse MBS and then sold as if they were the average MBS (see Pro Publica on the Magnetar CDO’s here). Some buyers did not check whether or not the dice were loaded.
But the important fact to keep in mind as the legal saga unfolds is that, so far, while one should always and everywhere prosecute securities fraud, this is chump change relative to the real causes of the financial crisis and should not be the primary focus of the new financial architecture. Although there is an important caveat. There may be many more instances of fraudulent sales of MBS. If this is the case, do we need to try to protect large financial institutions that manage other people’s money? Are they really so unsophisticated as to get up and dance just because everyone else is? I hope not.