John Kenneth Galbraith wrote about the role of investment trusts (and Goldman Sachs) in The Great Crash of 1929.
ProPublica has written an investigative report called “Banks' Self-Dealing Super-Charged Financial Crisis” by Jake Bernstein and Jesse Eisinger. In it they describe how the largest banks in the US (including Goldman Sachs) created CDOs that helped propel the present financial crisis.
Together, these two events produce a kind of deja vu especially in the way that financial products were created, i.e., investment trusts before The Great Crash and CDOs in The Great Recession, as follows:
The introduction to Galbraith's work talks about “...investment trusts would sponsor investment trusts that would, in turn sponsor investment trusts.”
Whereas, ProPublica states “...a CDO would buy a piece of another CDO which returned the favor....So the banks create...new CDOs. Those new CDOs bought hard-to-sell pieces of orginal CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its risky pieces. Banks created yet other CDOs to buy those.”
How very familiar, and similar, these two events appear!
The portion of CDOs owned by other CDOs grew right alongside the market. What had been 5 percent of CDOs (remember the "bucket") now came to constitute as much as 30 or 40 percent of new CDOs. (Wall Street also rolled out CDOs that were almost entirely made up of CDOs, called CDO squareds .)
The ever-expanding bucket provided new opportunities for incestuous trades.
It worked like this: A CDO would buy a piece of another CDO, which then returned the favor. The transactions moved both CDOs closer to completion, when bankers and managers would receive their fees.
ProPublica's analysis shows that in the final two years of the business, CDOs with cross-ownership amounted to about one-fifth of the market, about $107 billion.
Here's an example from early May 2007:
A CDO called Jupiter VI bought a piece of a CDO called Tazlina II.
Tazlina II bought a piece of Jupiter VI.
Both Jupiter VI and Tazlina II were created by Merrill and were completed within a week of each other. . . .
Citigroup did its own version of the shuffle, as these three CDOs demonstrate:
A CDO called Octonion bought some of Adams Square Funding II.
Adams Square II bought a piece of Octonion.
A third CDO, Class V Funding III, also bought some of Octonion.
Octonion, in turn, bought a piece of Class V Funding III.
All of these Citi deals were completed within days of each other. . . .
ProPublica also tabled a circle graph of “CDOs created by one bank [that]commonly purchased slices of other CDOs created by the same bank.” Shown in the third tier are the number of deals in which Goldman Sachs's “CDOs held a significant portion of their own prior CDOs. “
The table can be seen here
Read the full article here
Below is an excerpt from the Introduction to“In Goldman, Sachs We Trust” by John Kenneth Galbraith (1908–2006)
From John Kenneth Galbraith: The Affluent Society and Other Writings 1952–1967 - in The Library of America – The Story of the Week
. . . .
One method of increasing the number of stocks, relatively new in the U.S., was the creation of the investment trust. Such companies did not really produce anything or foster new enterprises; instead, they “merely arranged that people could own stock in old companies through the medium of new ones”; that is, the trust’s sole purpose was to invest its funds in the stocks of other companies. The problem, however, was that there was often no relation to the amount of money invested in the trust to the amount of money the trust invested, in turn, in stocks. “The difference,” Galbraith writes, “went into the call market, real estate, or the pockets of the promoters.”
The investment trusts succeeded largely because the “product” they sold to the average trader was expertise: “One might make money investing directly in Radio, J. I. Case, or Montgomery Ward, but how much safer and wiser to let it be accomplished by the men of peculiar knowledge, and wisdom.” And the trusts were not really new companies; instead, most of them were sponsored by existing companies—for example, J.P. Morgan was behind the investment trust United Corporation. Furthermore, it almost goes without saying, investment trusts would sponsor investment trusts that would, in turn sponsor investment trusts; each of these companies issuing stocks that they would often sell to each other or to other investment trusts. Many of these companies learned quickly that through the “the miracle of leverage” (the degree to which borrowed money is used), they could “swing a second and larger [trust] which enhanced the gains and made possible a third and still bigger trust.”
. . . .
Please read the full essay, In Goldman, Sachs We Trust, by Galbraith here