Accidentally Released - and Incredibly Embarrassing - Documents Show How Goldman et al Engaged in 'Naked Short Selling'

Rolling Stone
Matt Taibbi

It doesn’t happen often, but sometimes God smiles on us. Last week, he smiled on investigative reporters everywhere, when the lawyers for Goldman, Sachs slipped on one whopper of a legal banana peel, inadvertently delivering some of the bank’s darker secrets into the hands of the public.

The lawyers for Goldman and Bank of America/Merrill Lynch have been involved in a legal battle for some time – primarily with the retail giant Overstock.com, but also with Rolling Stone, the Economist, Bloomberg, and the New York Times. The banks have been fighting us to keep sealed certain documents that surfaced in the discovery process of an ultimately unsuccessful lawsuit filed by Overstock against the banks.

Last week, in response to an Overstock.com motion to unseal certain documents, the banks’ lawyers, apparently accidentally, filed an unredacted version of Overstock’s motion as an exhibit in their declaration of opposition to that motion. In doing so, they inadvertently entered into the public record a sort of greatest-hits selection of the very material they’ve been fighting for years to keep sealed.

I contacted Morgan Lewis, the firm that represents Goldman in this matter, earlier today, but they haven’t commented as of yet. I wonder if the poor lawyer who FUBARred this thing has already had his organs harvested; his panic is almost palpable in the air. It is both terrible and hilarious to contemplate. The bank has spent a fortune in legal fees trying to keep this material out of the public eye, and here one of their own lawyers goes and dumps it out on the street.

The lawsuit between Overstock and the banks concerned a phenomenon called naked short-selling, a kind of high-finance counterfeiting that, especially prior to the introduction of new regulations in 2008, short-sellers could use to artificially depress the value of the stocks they’ve bet against. The subject of naked short-selling is a) highly technical, and b) very controversial on Wall Street, with many pundits in the financial press for years treating the phenomenon as the stuff of myths and conspiracy theories.

Now, however, through the magic of this unredacted document, the public will be able to see for itself what the banks’ attitudes are not just toward the “mythical” practice of naked short selling (hint: they volubly confess to the activity, in writing), but toward regulations and laws in general.

Wall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments

Ellen Brown

Far from reducing risk, derivatives increase risk, often with catastrophic results.

—   Derivatives expert Satyajit Das, Extreme Money (2011)

The “toxic culture of greed” on Wall Street was highlighted again last week, when Greg Smith went public with his resignation from Goldman Sachs in a scathing oped published in the New York Times.  In other recent eyebrow-raisers, LIBOR rates—the benchmark interest rates involved in interest rate swaps—were shown to be manipulated by the banks that would have to pay up; and the objectivity of the ISDA (International Swaps and Derivatives Association) was called into question, when a 50% haircut for creditors was not declared a “default” requiring counterparties to pay on credit default swaps on Greek sovereign debt.

Interest rate swaps are less often in the news than credit default swaps, but they are far more important in terms of revenue, composing fully 82% of the derivatives trade.  In February, JP Morgan Chase revealed that it had cleared $1.4 billion in revenue on trading interest rate swaps in 2011, making them one of the bank’s biggest sources of profit.  According to the Bank for International Settlements:
[I]nterest rate swaps are the largest component of the global OTC derivative market.  The notional amount outstanding as of June 2009 in OTC interest rate swaps was $342 trillion, up from $310 trillion in Dec 2007.  The gross market value was $13.9 trillion in June 2009, up from $6.2 trillion in Dec 2007.

For more than a decade, banks and insurance companies convinced local governments, hospitals, universities and other non-profits that interest rate swaps would lower interest rates on bonds sold for public projects such as roads, bridges and schools.  The swaps were entered into to insure against a rise in interest rates; but instead, interest rates fell to historically low levels.  This was not a flood, earthquake, or other insurable risk due to environmental unknowns or “acts of God.”  It was a deliberate, manipulated move by the Fed, acting to save the banks from their own folly in precipitating the credit crisis of 2008.  The banks got in trouble, and the Federal Reserve and federal government rushed in to bail them out, rewarding them for their misdeeds at the expense of the taxpayers.
 How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”:

In an interest-rate swap, two parties exchange payments on an agreed-upon amount of principal. Most of the swaps Wall Street sold in the municipal market required borrowers to issue long-term securities with interest rates that changed every week or month. The borrowers would then exchange payments, leaving them paying a fixed-rate to a bank or insurance company and receiving a variable rate in return. Sometimes borrowers got lump sums for entering agreements.

Banks and borrowers were supposed to be paying equal rates: the fat years would balance out the lean.  But the Fed artificially manipulated the rates to the save the banks.  After the credit crisis broke out, borrowers had to continue selling adjustable-rate securities at auction under the deals.  Auction interest rates soared when bond insurers’ ratings were downgraded because of subprime mortgage losses; but the periodic payments that banks made to borrowers as part of the swaps plunged, because they were linked to benchmarks such as Federal Reserve lending rates, which were slashed to almost zero.