Goldman-plated excuses
My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. Basically, the SEC claims that Goldman failed to disclose a conflict of interest in a deal the firm arranged, that perhaps Goldman even misdirected and misimplied and failed to correct impressions that were untrue but helpful in getting the deal done. If that’s the worst the SEC could dig up, I thought, there’s way too much that’s legal. Had you asked me, early Friday afternoon, what would happen, I would have pointed to the “global settlement” seven years ago. Then as now, investment banks were caught fibbing to keep the deal flow going (then via equity analysts who hyped stocks they privately did not admire). The settlement got a lot of press, the banks were slapped with fines that sounded big but didn’t matter, promises were made about “chinese walls” and stuff, nothing much changed.
But Goldman’s PR people have once again proved themselves to be masters of ineptitude. Haven’t those guys ever heard, “it’s not the crime, but the cover up”? The SEC threw Goldman a huge softball by focusing almost entirely on the fibs of a guy who calls himself “the fabulous Fab” and makes bizarre apocalyptic boasts. Given the apparent facts of this case, phrases like “bad apple” and “regret” and “large organization” and “improved controls” would have been apropos. It’s almost poignant: The smart thing for Goldman would be to hang this fab Fab out to dry, but whether out of loyalty or arrogance the firm is standing by its man.
But Goldman’s attempts to justify what occurred, rather than dispute the facts or apologize, could be the firm’s death warrant. The brilliant can be so blind.
The core issues are simple. Goldman arranged the construction of a security, a “synthetic CDO”, which it then marketed to investors. No problem there, that’s part of what Goldman does. Further, the deal wasn’t Goldman’s idea. The firm was working to serve a client, John Paulson, who had a bearish view of the housing market and was looking for a vehicle by which he could invest in that view. Again, no problem. I’d argue even argue that, had Goldman done its job well, it would have done a public service by finding ways to get bearish views into a market that was structurally difficult to short and prone to overpricing.
Goldman could, quite ethically, have acted as a broker. Had there been some existing security that Paulson wished to sell short, the firm might have borrowed that security on Paulson’s behalf and sold it to a willing buyer without making any representations whatsoever about the nature of the security or the identity of its seller. Apparently, however, the menu of available securities was insufficient to express Paulson’s view. Fine. Goldman could have tailored a security or derivative contract to Paulson’s specifications and found a counterparty willing to take the other side of the bet in full knowledge of the disagreement. Goldman needn’t (and shouldn’t) proffer an opinion on the substantive economic issue (was the subprime RMBS market going to implode or not?). Investors get to disagree. But it did need to ensure that all parties to an arrangement that it midwifed understood the nature of the disagreement, the substance of the bet each side was taking. And it did need to ensure that the parties knew there was a disagreement.
Goldman argues that the nature of the security was such that “sophisticated investors” would know that they were taking one of two opposing positions in a disagreement. On this, Goldman is simply full of it:
Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side. [bold original, italics mine]
The line I’ve italicized is the sole inspiration for this rambling jeremiad. That line is so absurd, brazen, and misleading that I snorted when I encountered it. Of course it is true, in a formal sense. Every financial contract — every security or derivative or insurance policy — includes both long and short positions. Financial contracts are promises to pay. There is always a payer and a payee, and the payee is “long” certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. Old stakeholders commit to pay dividends to new shareholders because managers believe the cash they receive up front will enable business activity worth more than the extra cost. New shareholders buy the shares because they agree with old stakeholders’ optimism. The existence of a long side and a short side need imply no disagreement whatsoever.
So why did Goldman put that line in their deeply misguided press release? One word: derivatives. The financially interested community, like any other group of humans, has its unexamined clichés. One of those is that derivatives are zero sum contests between ‘long’ investors and ‘short’ investors whose interests are diametrically opposed and who transact only because they disagree. By making CDOs, synthetic CDOs sound like derivatives, Goldman is trying to imply that investors must have known they were playing against an opponent, taking one side of a zero-sum gamble that they happened to lose.
Of course that’s bullshit. Synthetic CDOs are constructed, in part, from derivatives. (They are built by mixing ultrasafe “collateral securities” like Treasury bonds with credit default swap positions, and credit default swaps are derivatives.) But investments in synthetic CDOs are not derivatives, they are securities. While the constituent credit default swaps “necessarily” include both a long and a short position, the synthetic CDOs include both a long and a short position only in the same way that IBM shares include both a long and a short position. Speculative short interest in whole CDOs was rare, much less common than for shares of IBM. Investors might have understood, in theory, that a short-seller could buy protection on a diversified portfolio of credit default swaps that mimicked the CDO “reference portfolio”, or could even buy protection on tranches of the CDO itself to express a bearish view on the structure. But CDO investors would not expect that anyone was actually doing this. It would seem like a dumb idea, since CDO portfolios were supposed to be chosen and diversified to reduce the risk of loss relative to holding any particular one of its constituents, and senior tranches were protected by overcollateralization and priority. Most of a CDO’s structure was AAA debt, generally viewed as a means of earning low-risk yield, not as a vehicle for speculation. Synthetic CDOs were composed of CDS positions backed by many unrelated counterparties, not one speculative seller. Goldman’s claim that “market makers do not disclose the identities of a buyer to a seller” is laughable and disingenuous. A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties. The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.
I have little sympathy for CDO investors. Wait, scratch that. I have a great deal of sympathy for the beneficial investors in CDOs, for the workers whose pensions won’t be there or the students at colleges strapped for resources after their endowments were hit. But I have no sympathy for their agents and delegates, the well-paid “professionals” who placed funds entrusted them in a foolish, overhyped fad. But what investment managers believed about their hula-hoop is not what Goldman now hints that they believed. Investors in synthetic CDOs did not view themselves as taking one side of a speculative gamble against a “short” holding opposite views. They had a theory about their investments that involved no disagreement whatsoever, no conflict between longs and shorts. It went like this:
There is a great deal of demand for safe assets in the world right now, and insufficient supply at reasonable yields. So, investors are synthesizing safe assets by purchasing riskier debt (like residential mortgage-backed securities) and buying credit default swaps to protect themselves. All that hedging is driving up the price of CDS protection to attractive levels, given the relative safety of the bonds. We might be interested in capturing those cash flows, but we also want safe debt. So, we propose to diversify across a large portfolio of overpriced CDS and divide the cash flows from the diversified portfolio into tranches. If we do this, those with “first claims” on the money should be able to earn decent yields with very little risk.
I don’t want to say anything nice about that story. The idea that an investor should earn perfectly safe, above-risk-free yields via blind diversification, with little analysis of the real economic basis for their investment, is offensive to me and, events have shown, was false. But this was the story that justified the entire synthetic CDO business, and it involved no disagreement among investors. According to the story, the people buying the overpriced CDS protection, the “shorts” were not hoping or expressing a view that their bonds would fail. They were hedging, protecting themselves against the possibility of failure. There needn’t have been any disagreement about price. The RMBS investors may have believed that they were overpaying for protection, just as CDO buyers did, just as we all knowingly and happily overpay for insurance on our homes. Shedding great risk is worth accepting a small negative expected return. That derivatives are a zero-sum game may be a cliché, but it is false. Derivatives are zero-sum games in a financial sense, but they can be positive sum games in an economic sense, because hedgers are made better off when they shed risk, even when they overpay speculators in expected value terms to do so. (If there are “natural” hedgers on both sides of the market, no one need overpay and the potential economic benefits of derivatives are even stronger. But there are few natural protection sellers in the CDS market.)
Goldman claims to have lost money on the CDO it created for Paulson. Perhaps the bankers thought Paulson was a patsy, that his bearish bets were idiotic and they were doing investors no harm by hiding his futile meddling. Perhaps, as Felix Salmon suggests, the employees doing the deal had little reason to care about whether the part of the structure Goldman retained performed, as long as they could book a fee. It is likely that even if Paulson had had nothing to do with the deal, the CDO would still have failed, given how catastrophically idiotic RMBS-backed CDOs were soon revealed to be.
But all of that is irrelevant, assuming the SEC has the facts right. Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care. Given the amount of CYA boilerplate in Goldman’s presentation of the deal, maybe they immunized themselves. But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die.
Great piece as usual. But I am going to disagree a little.
I actually believe in the difference between “cash” and “synthetic” securities in the sense Goldman (and Wall Street) do. When you buy a share of IBM, you are not buying it from IBM; you are buying it from somebody else. If that seller already owns IBM, it is incorrect to say they are taking a short position. Someone reducing an existing IBM position might have many reasons; someone borrowing shares in order to short them has only one.
Goldman’s statement is specifically contrasting cash CDOs with synthetic CDOs. The former is a security (like a stock); the latter is a bet (like an option). A synthetic CDO, by definition, is “protection on a diversified portfolio of credit default swaps that mimics the CDO ‘reference portfolio'”.
You can argue that IBM is “short its own stock”, but I still think that represents a very different relationship than when you buy an option, which is a specific contract between two parties taking opposite sides of a specific bet. Similarly, you can argue that everyone with a mortgage was “short the CDO”, but again, that is very different from the synthetic CDO where derivatives were used to construct opposite sides of a very specific bet between very specific parties regarding the performance of millions of mortgages in aggregate.
In short, I buy that aspect of Goldman’s defense. Where the defense falls down, of course, you describe in your last paragraph: Paulson not only took the other side of the bet, he actively selected the reference portfolio, and Goldman lied about that fact. (I am not a lawyer, so I get to say “lied” instead of “is alleged to have misrepresented”.) Of course sophisticated investors know that someone is on the other side of their “bets”; the problem is that the statement is trivial, and it is irrelevant to the substance of the allegation.
April 17th, 2010 at 8:56 am PDT
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I believe client confidentially laws might actually even prevent GS from disclosing the position Paulson had taken. As Nemo says, there was someone shorting it as that was the nature of the CDO, and the investors would have known that. If anything, this thing points to ACA being fully incompetent for not realising what Paulson was up to (they should have known the track record of the hedge fund) and allowing Paulson to have a say in the selection of it.
April 17th, 2010 at 9:25 am PDT
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interesting, Steve, because i was about to sit down and write a piece about how these synthetic CDOs were EXACTLY over the counter prop bets where the profits that the winner gets come directly from the corresponding loser on the other side of the trade.
you seem to try to justify this away by saying that the buyers of the SynthCDOs didn’t realize that (that this was a “someone wins, the other guy loses” trade) – but again, that’s their own ignorance if their world view was misguided.
i agree with Nemo’s comment that the IBM analogy might confuse readers. If you buy IBM in the market, do you care if the person selling it to you is long or short? does that change the value of IBM? IBM is still IBM regardless of if the shares come from a primary offering by the company, a secondary market sale from another investor, or a short sale from someone else. The shares should be evaluated based on the business – just like these SynthCDOs should be evaluated based on the underlying RMBS – NOT based on who chose the portfolios or who was on which side.
i’m not sure any of this matters from GS’s point of view, except that even if GS is guilty of failure to disclose, I am adamant that ACA is still not a victim. It sounds like you feel similarly.
April 17th, 2010 at 9:37 am PDT
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Somebody HAS to originate protection buying on the reference portfolio in order to create a synthetic CDO. Whether that originates from different counterparties – or from a single player – is a secondary issue, although it may become important in the circumstances.
At the macro level, the creation of a synthetic CDO has no effect on the configuration of assets and liabilities from a hedging perspective. It can’t – not at the macro level – because it has no net effect on cash instruments referencing or around the risk in question. In that sense, the creation of synthetics certainly is a zero sum game at the macro margin. And in that regard, non-zero net macro adjustment for the totality of cash and synthetics requires micro cash adjustment. It can’t happen through synthetics.
At the micro level, therefore, there is no logical reason for any synthetic CDO buyer (protection seller to the CDO) to start making assumptions about the hedging or speculative motivations of those counterparties who are originating protection buying into the CDO (or on it).
Regarding the Goldman case, my reading of the details so far leads me to believe that Goldman will escape, provided ASA had no written documentation to the effect that Paulson would be an equity investor (the SEC charge alleges ASA was led to believe this).
It also strikes me that ASA must have been incredibly stupid to sit down with Paulson and communicate by email, and then finally agree to a reference portfolio, apparently without confirming in unambiguous terms that Paulson would be an equity investor and/or not a protection buyer. After all, ASA/AMBRO ended up being the largest notional investor, losing close to $ 1 billion on the super senior position.
It is ASA who should really be sued here, if they were still around. Their stupidity as CDO manager far exceeded Goldman’s deviousness as arranger.
I find the IBM analogy a bit weak, mostly because you’re talking about IBM equity. IBM as a firm has no investor personality other than that of its owners. It is the owners of the firm who are effectively short IBM debt (and long the corresponding put option), not IBM that is short its “own” equity. Conversely, IBM stock held by an investor may be subject to long or short positioning. It is a tradable financial asset – unlike the actual balance sheet equity position of the entity known as IBM.
And the market price of IBM’s equity has no DIRECT effect on its operational performance. IBM’s operational performance incorporates its balance sheet equity position, which is substantially separate from the valuation of that equity position as a financial claim. One might argue that IBM could buy back its own stock at lower prices, but such a buyback per se is of no AGGREGATE benefit to the EXISTING owners of the firm. And it risks jeopardizing the firm’s capital position.
April 17th, 2010 at 11:28 am PDT
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Uh…You appear to not understand the difference between cash and synthetics CDOs. This was a synthetic. Nobody in the transaction physically had to hold the underliers. Therefore it very much was a zero sum deal.
April 17th, 2010 at 11:59 am PDT
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By the way, CDOs aren’t built out of CDS. I don’t know what gave you that idea. CDOs are built out of underlying debt obligations (eg mortgage bonds in this case). The synthetic part means that one party agreed to pay the other party the cashflows from the underliers without actually holding them. The short on this transaction wins if the underliers default or otherwise depreciate.
April 17th, 2010 at 12:16 pm PDT
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It’s true that synthetic cdos can be built using cds, but all this means is that going long the synthetic is equal to selling protection, another zero sum activity.
April 17th, 2010 at 12:21 pm PDT
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Wonderful to see the State trying to do something other than transfer wealth to the banking industry, but I’m pretty sure that GS will win this. In doing so, a lot of people will end up learning a lot more about what banks really do each day, and I believe/hope that this is what will drive reform in the right direction.
Sorry to be the one to tell you, but finding people who don’t like X and want to sell it, and then finding people who do like X and want to buy it, is essentially what an awful lot of people- not just bankers – do all day. But, you say, if X is nuclear waste, surely the people who move it from sellers to buyers should be put in prison!! The detail you’re missing is something called a PRICE. Everyone wants to sell pretty much anything at some price, and there’s a pretty small list of things that people won’t buy at zero-ish. What happens in finance is someone thinks that X is worth selling at price P and someone else thinks it’s worth buying at P. That happens with a company issuing a shares, someone issuing debt/borrowing money, and with banks buying and selling securities. Of course you can’t tell the buyer who the seller is – you’d be successfully sued if you did that. One assumes that people can figure out what they’re buying and decide if they like the price. If you like X at some price P, I could source it from a third party or in some cases I could find a way to short it to you. What do you care where it came from, and whether or not I’ve broked it to you or shorted it myself? Go figure out what you’re buying and decide if you like the price, and buy it somewhere else if you can get it cheaper. That’s the kind of thing that happens every second every day in the financial markets.
People at some point need to get the joke about what banks actually do. It’s not about taking deposits and lending money to job-creating commerical enterprises. It’s about taking every rule and regulation you operate within, every contract you can trade or dream up, and every customer who’ll accept your phone call, and out of all this finding ways to make yourself and your boss wealthy. Banks are nothing more than wealth-creation vehicles for management. In terms of business model, they’re just like hedge funds, but with cheaper capital (now much cheaper with the kind support recently provided). Clients, relationships and reputation are imporant insofar as they represent ways to make money. It’s really staggeringly simply, and certainly not illegal.
April 17th, 2010 at 2:06 pm PDT
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It’s difficult to assess the ethics of these things as they would have appeared to everyone at the time (the proper standard of judgment), instead of how they look now with the benefit of hindsight.
The legal question hinges, at least in part, on “causality”, or the issue of whether, had full disclosure been made in the most ethical manner possible, it would have made all that much difference. Maybe a little in enthusiasm and pricing, or the particular buyers, but I somehow still think GS would have sold them all to someone on approximately the same terms.
The disclosure might have looks like this: “These particular portfolios were created at the behest of a world-class trader who has adopted a minority ultra-bearish contrarian view, opposed to the opinions of the vast majority of market participants. John, almost alone, thinks the whole housing market is a bubble that’s going to crash instead of plateau (which is what most analysts are currently saying), and that if that unexpected event should occur, that these particular assets are going to tank the hardest, and he very much wants to bet that way consistent with his opinions, *and he’s willing to pay a premium to do so which theoretically might make these cheaper for you than otherwise*. However, please note that almost no one else or major super-smart-and-sophisticated giant financial institution (including us, since we’re holding these things too) believes that or behaves that way or predicts a similar outcome. And if Paulson is wrong, which, again, is probably given that those infallible rating-agencies label this stuff good as gold, then this provides an awesome yield for trivial risk – better even than bonds. So, what’s it gonna be, eh?”
Now, looking back from the present, I know it’s going to sound absurd for me to suggest other than that every sane person who heard that and took some time to think about it would have simply walked away from the table. But … back then; enthusiasm being what it was, and confidence and optimism and consensus, and so on, etc. I think they would have stayed to play despite the disclosure, and probably would have smirked smugly at how they were taking candy from a baby by letting that sucker Paulson act on his crazy, wild hunch.
Now, if the investors could produce a policy memorandum which instructed the traders of that era never to purchase assets of the type we’re discussing, in other words, that they demonstrably wouldn’t or couldn’t have done what they did if they would have known the whole truth, well, then Goldman’s just in deep trouble. But does such a magical document exist? I doubt it.
April 17th, 2010 at 2:51 pm PDT
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I’m not convinced by Felix’s re-interpretation of your post.
“The point here is not just that IKB thought that ACA had carefully selected the portfolio with an eye to optimizing its performance on the long side; it’s also that ACA thought that Paulson had carefully selected its longlist of potential components for the portfolio with exactly the same view to making money by selling insurance to people wanting to hedge their mortgage exposure. Goldman, by failing to disabuse its client ACA of this notion, behaved unethically”
Reading the SEC complaint, it is clear that ACA and Paulson met face to face several times, with intermittent email communication. The contact was direct – not channelled via GSC. How is it possible that ACA could not ask the right questions during such a meeting and direct email communication process? As reported in the complaint, “Fab” thought one of the direct meetings to be “surreal”. Paulson had a reputation for shorting the mortgage market well before that meeting. How could ACA not ask the necessary questions? And ACA was the largest nominal long investor as well as the CDO manager! It’s not only that ACA knew Paulson was involved – as Felix says – it’s that ACA itself was directly involved WITH Paulson. Apparently they NEVER actually asked the question as to why Paulson was involved. And that’s why Goldman will escape this. This was gross incompetence on ACA’s part.
April 17th, 2010 at 3:36 pm PDT
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I want to agree with those above and reiterate the fact that synthetic CDOs are, by definition, a zero sum game. And you seem to et at the nub of another GS defense above when you say: ” It is likely that even if Paulson had had nothing to do with the deal, the CDO would still have failed, given how catastrophically idiotic RMBS-backed CDOs were soon revealed to be.” If the market for CDOs is efficient (and its a pretty big if, but not an insuperable burden) it shouldn’t have mattered what CDOs were in the mix, just as all portfolios of stocks should earn about the market rate of return (there are obviousvolatility issues, of course, but that should all be in the prospectus boilerplate). If I want to get the reurn of a bunch of AAA-rated securities and I’m not willing to pick them myself, why the hell should it matter who picked them? As a colleague asked me: would you be willing to invest in a mutual fund whose stocks were picked by shorts to fail? My answer: yep.
April 17th, 2010 at 3:44 pm PDT
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I’m going to put my problem with this case hypothetically, so that I can focus on what bothers me, which might not be unethical or illegal.
In 2005, I start investing against companies I believe have committed Fraud, Collusion, Negligence, or Fiduciary Mismanagement. I believe that their statements are faulty. So far, I’m ok with that.
But then I go to a middleman. I say I want you to sell a portfolio of investments that are going to implode because of malfeasance, not just because of business mistakes. The middleman then goes looking for someone to buy this portfolio. Of course, the books are going to appear ok to them. I know that.
Is there anything weird about that transaction? It’s the part or role of the middleman that bothers me. Am I assuming that they, too, are a little iffy, in using them? If so, was I right? Do they need to disclose the added negative possibility?
April 17th, 2010 at 6:10 pm PDT
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Follow up comments:
“But it did need to ensure that all parties to an arrangement that it midwifed understood the nature of the disagreement, the substance of the bet each side was taking. And it did need to ensure that the parties knew there was a disagreement.”
Why?
If I buy Goldman Sachs stock, I don’t get to know whether the seller shorted it.
Why should the rules be fundamentally different in this case? What’s preventing the buyer from doing due diligence on the structural characteristics of the security, absent knowing who contributed to that structure?
There is no reason why it should be fundamentally different.
“Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not.”
Inappropriate analogy, as noted earlier. The IBM equity investor is short a put on IBM’s assets, by construction. But IBM, the firm, is not short equity. IBM, the firm, has not borrowed and sold IBM stock in order to buy it back at a lower price. IBM has a structural requirement for equity due to the unique capital functionality of equity for IBM’s balance sheet. That’s hardly construable as a short position. Shorts don’t require that sort of capital functionality.
“By making CDOs, synthetic CDOs sound like derivatives”
They are derivatives in terms of the risk transfer required by construction within the CDO itself. The risk transfer is effected by CDS or CDS like cash flows that are essentially outright put options, unlike the embedded put options contained in cash debt or equity.
“the synthetic CDOs include both a long and a short position only in the same way that IBM shares include both a long and a short position.”
No. See previous comment. The decomposition of the risk transfer derivative structure within the CDO is explicit – not implicit as in an IBM share or bond. The CDO does not hold the cash reference portfolio.
“The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties.”
I think you’re making up a somewhat arbitrary and discretionary rule here about a requirement for “variety”. What’s the fundamental difference between a set of shorts and a single short in terms of the requirements for that side of a CDO structure?
“the CDO’s investors did not view themselves as speculators”
Whatever their view of themselves was, it doesn’t matter. They were looking for yield from an exotically chopped up cash flow structure. Whether they were viewed by anybody including themselves as speculating or hedging doesn’t matter.
April 17th, 2010 at 6:38 pm PDT
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The sales brochure http://www.scribd.com/doc/30059004/30036962-Abacus-2007-Ac1-Flipbook-20070226 is entirely upfront about there being a counterparty who is betting on fail.
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Goldman Sachs will enter into a CDS with the Issuer to buy protection on Reference Portfolio losses
related to the Class A through Class D Notes.
−
The Collateral Securities and/or Eligible Investments will be available to make payments to
Goldman Sachs in the case of writedowns or other Credit Events occurring on the Reference
Portfolio, which in each case incur writedowns on the Class A through Class D Notes
————–
The deception in the presentation is the claim that ACA did due diligence and knew what they were doing. Essentially, the sell is to participate with ACA in an investment that will be safe and profitable because ACA is an expert in the market and is selecting safe investments.
So, to me: IKB were grossly negligent and their management should not have been managing millions of Euros of other people’s money because they were clearly unqualified and ACA acted deceptively in presenting Paulson’s choices as their careful investment plan, BUT Goldman did not act in good faith. Can I vote for life on the chain gang for all parties?
April 17th, 2010 at 7:24 pm PDT
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The SEC suit contends that Goldman was required to disclose the relationship with Paulson under the Securities and Exchange Act. I assume synthetic CDOs are covered under this act or else the SEC would not have brought these charges (if anyone knows different, do tell). The requirements of the act are relatively broad and I think certainly would have required Goldman to disclose. Again, if someone sees this different, I’m interested in hearing.
April 17th, 2010 at 8:17 pm PDT
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GS certainly wasn’t acting in good faith but they weren’t acting as an agent or investment advisor for IKB, ACA, ABN. GS didn’t lie about the collateral in the CDO and GS didn’t hide the fact that they were going to buy protection on the CDO. S&P rated the structure!
What else should GS have told ABN, IKB, ACA — we wouldn’t be caught dead selling protection on this pool because we think it is garbage and we don’t trust S&P and neither should you?
Is it really news that GS views their customers as chumps and fools? Maybe because their customers are chumps and fools.
April 17th, 2010 at 8:35 pm PDT
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LongAndShort’s last point IS the biggest risk to GS future profitability – if enough GS clients conclude that it’s too risky to deal with GS (given risk of being played and having ur face ripped off, compared to say dealing with JPM, UBS, BofA, CreditSuisse, MorgStan, etc.) then GS will be forced to shrink – GS’ ability to do these kinds of trades depends on them maintaining their rep as serving their clients, but in the last 15mths they have completely misplayed the PR game (with arrogance and dismissiveness characteristic of the high school computer/math/chess club vs the rest of the student body) which is consistent with having the c-suite be devoid of well-rounded (indeed, perhaps less intelligent) managers…..since they are all ex-traders
April 17th, 2010 at 8:58 pm PDT
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Thanks as always for the great comments (and my apologies to regular commenters for being badly in arrears in responding re the previous post).
Regarding the distinction between “cash” and “synthetic” securities, I’m going to push back a bit. I think there is far less than meets the eye to that distinction than many commenters think.
It is simply a fact that every financial contract, including those that describe common equity, standard debt, Treasury securities, credit default swaps, interest rate swaps, options, etc. are legal instruments that provide for contingent transfers of cash. (There are complications and variations — equity is bundled with control rights, some futures and options may be settled “in kind” rather than in cash. For the sake of this conversation, we are talking about contracts that settle in cash and don’t involve any exchange of goods or services.) In such contracts, every payment is zero sum. Someone pays, somebody receives. Contracts differ in terms of the timing of payments — the contracts traditionally referred to as “cash” often involve an early large payment by one party and smaller later payments by the other party. But, credit default swaps increasingly require a chunky prepayment. (All kinds of contracts, loans, forward contracts, etc. use a wide variety of toos to ensure fulfilment, ranging from collateral to netting arrangements to different degrees of recourse.) Contracts described as “derivatives” are often associated with very contingent cash flows, but “cash” equity is also associated with very contingent cash flows.
What matters is the economic substance of a transaction, not its legal form. Putting aside control rights, consider the following arrangement: I offer IBM a perpetual loan of $1M at LIBOR + 2%. Simultaneously, IBM and I enter into a perpetual total return swap on IBM shares, whereunder I pay LIBOR + 2% and IBM pays me the total return on its shares. This arrangement is economically very close to a new equity issue by IBM. But it is clear that IBM is on the short side of a swap with me. There is a loan, which compels fixed payments, and a variable piece which is a zero-sum derivative transaction, where my gains are IBM’s losses. But IBM only loses in “good states of the world”, when it’s stock is riding high, so unless IBM enters into hugely too many transactions like this, the firm and its “real” shareholders prefer to lose than to win. This may be good financing for IBM, as the cost of financing covaries with the fortunes of the firm.
My use of a firm being short its own equity confused people, and that’s my fault — I was going for the most familiar and vanilla instrument I could in order to make my point, but I didn’t state clearly enough “who” is on the short side when a firm issues new stock. “The firm” was too vague. If there is a pre-existing firm, the issue of new equity amounts to preexisting shareholders taking a “short” position and new investors taking a “long” position, in exchange for usable cash. Assuming that the new issue doesn’t affect control, the situation for old investors is identical to the synthetic arrangement described above. When the firm does well, old investors lose money relative to what they hypothetically could have kept if it weren’t for the new shareholders. However, absent the finance provided by the new shareholders, perhaps the firm would not have done so well, so ex ante committing to pay is smart and ex post old shareholders prefer to let new shareholder share the wealth than to have no wealth at all. In real life frictions, transaction costs, regulatory and accounting issues would matter, and in practice determine the form of actual arrangements.
But in terms of basic economics, the story I am telling is true. We can synthesize equity as easily as we synthesize RMBS in the Abacus CDO. But the economics of the arrangement are determined by the character of the full portfolio and the interests of the various counterparties. That one piece of the arrangement is a no-cash-upfront, zero-sum contract is interesting, but doesn’t tell us much about the economics of the arrangement on its own.
I don’t mean to suggest that economically similar arrangements are perfectly interchangeable. If you want control rights to a firm, you must own “cash” equity rather than hold an equity position you could have synthesized in any number of ways. But it is never enough to say this was a “synthetic CDO, so there must be a long and a short”. Economically, there is always a long and a short with respect to any potential payment. To make a meaningful case, you have to explain something more about the character of the arrangement than that. Goldman’s statement struck me as manipulative, in that it the firm was trying to analogize the ABACUS CDOs to isolated, speculative derivative contracts when the mere fact of “long” and “short” has no meaning.
People who want to make a big deal of the “synthetic” vs “cash” distinction should look into the form of the ABACUS CDOs. The ABACUS entities were investment companies that issued securities in a legal sense. They held portfolios of “cash” bonds, as well as taking positions in credit default swaps. The intention and economic effect of this was to simulate holding a portfolio of RMBS securities. A person holding a “cash” RMBS security is long what homeowners are short, and payments are zero-sum. But when mortgages are well underwritten, the interests of the long and short side of an RMBS are aligned: the homeowners don’t want to default, and the RMBS holder wants her coupon. Now, suppose the RMBS holder is uncomfortable with her risk, and would prefer Treasuries. She could sell her RMBS and buy Treasuries, but depending on market frictions and prices, she may find it more advantageous to buy credit protection and hold her position. ABACUS sells the protection. Now, in an economic sense, the situation is quite similar to a situation in which ABACUS holds the cash RMBS and the protection buyer holds Treasuries. No one in this picture, not the homeowner, not the protection buyer, and certainly not the CDO, has an interest (speculative or otherwise) in the RMBS defaulting. There are zero-sum transfers all over the place, but you can conclude nothing from that fact. All financial contracts describe the timing and contingency of zero-sum transfers. The meaning of those transfers depends on the details of the situation, not the form of the contract.
That’s not to say that we should be indifferent to the form of the contract. The CDO legal form is needlessly convoluted and complex. In an alternative world, suppose instead of ABACUS, CDO investors had simply purchased risk-free bonds and entered into a single total return swap on the reference portfolio of the CDO. That arrangement would have been economically almost identical to the actual Abacus CDO, but I bet that signers of such a contract would ask more questions about signing on directly to a total return swap than they do about purchasing a CDO security managed by a “professional”. CDOs are social institutions. They were crafted by finance professionals and designed to produce fees, and they slowly gained acceptance among various cadres of institutional investors whose investment behavior is driven primarily by yield competition and safe-harbor concerns. The fact that they were delegated products (selection and management was delegated to “professionals”) was attractive to this group of investors — it limited their personal risk. That aspect of the form of a CDO is far more informative to me than a simpleminded cash/synthetic distinction.
By the way, I absolutely don’t mean to absolve ACA or IKB and any other investors who signed onto this. ACA in particular performed ridiculously poorly. As you might gather from the graf above, I view the entire CDO industry as being shaped by agency issues, social factors, and legal conventions that promote shitty real investment, extract rents from the beneficial investors (pensioners, taxpayers, students, etc.) in order to financial intermediaries and “professional” money managers. There are no good guys in this picture. But Goldman’s behavior was pathetically bad.
BTW, if you look in the ABACUS “flipbook”, you’ll note that these were anticipated to be ERISA eligible securities, that is pension funds could safely include them in portfolios. Do you suppose the much more transparent and economically equivalent total return swap plus Treasuries arrangement would have been safe for an ERISA manager to choose? What’s safe for institutional investors is what’s delegated and opaque. I don’t imagine that’s coincidence. (I wouldn’t call it “conspiracy” either, just a kind of evolution into a self-serving-for-finance-professionals but economically destructive equilibrium.)
April 17th, 2010 at 9:09 pm PDT
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What GS should have told the customer was “this pool of assets was assembled at the request of a GS customer who will be purchasing the protection and the assets were selected by ACA from that customers initial list.”
But, to me, the appalling misconduct here is by ACA and IKB.
“At the reporting date, Contingent liabilities also comprised credit default swaps (where IKB has assumed the position of
protection seller) amounting to € 1.3 billion (2005/06: € 1.6 billion), within the Guarantees, warranties, other item. As
seller of protection we have assumed the risk of counterparty default for certain credit portfolios, given the occurrence of
pre-defined credit events. More than two-thirds of the individual portfolios are rated in the best rating classes Aaa to A by
the independent external rating agency Moody’s.”
http://www.ikb.de/content/en/ir/financial_reports/annual_report_2006_2007/IKB_AG_Jahresab_2007_eng.pdf
April 17th, 2010 at 9:20 pm PDT
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Steve Waldman: the revenue anticipated by the investors in this scam was from the CDS. Look at the box diagram on the flip chart page 50. Money comes in to the blue box in the middle from “collateral interest” and “CDS premium”. No?
April 17th, 2010 at 9:29 pm PDT
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Question: Why should Goldman tell that John Smith the carpenter or John Paulson the hedge fund manager is on the other side of the trade? Why does it really matter (at that point of time … circa Feb. 2007–remember that John Paulson was still an unknown entity though generally assumed as a bearish investor).
Think of an alternative scenario in which the sub prime securities paid decently well and Paulson ended up losing his shirt but the investors ended up gaining money in accordance with their risk appetite!
Obviously the crux of the case is contingent on the thinking that John Paulson would always be right and that he should be treated as some sort of demi-god and that everyone on the other side of every trade he is in should be alerted to the fact that one might be betting against John Paulson. Would that rule then apply to everyside of trades made by John Paulson, George Soros … and every other hedge fund … and every other pension fund?
But that is how a trade is made: you take one side and someone else takes the other side! A sophisticated bank like ABN Amro or even a moderate bank like the German bank wouldn’t have known that! Aha!
What about the emails sent by the trader within Goldman? Empty and idle speculation. Nothing in the complaint tells us that he might be “more informed” than anyone of us. It was empty speculation based on his conviction that John Paulson being on one side makes the other side necessarily idiotic. That need not be the case.
This case is based on what the SEC knows today (ie. John Paulson was indeed right) and hence Goldman should have told this to the investors on the other side.
The very fact that Goldman refused to settle it few days before tells me that they are confident–and rightly so–in taking up the SEC.
April 17th, 2010 at 9:35 pm PDT
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JKH — I want to address your point about the ethics of knowing/not knowing or informing/not informing whether a counterparty’s interest a speculative disagreement or motivated by hedging.
I agree with your broad point that in general, parties don’t know, and there is no reason for them to know.
But two points:
1) With standardized products, an investor can know in a statistical sense what she cannot know with respect to a specific transaction. Gold miners hedge as do wheat sellers, but qualitatively I suspect that the price of wheat futures is much more driven by hedging demand than the price of gold futures. As an investor, one always should ask oneself the question, “why would taking this position be more beneficial to me than to a counterparty willing to escape or oppose it?” Here are three answers: i) Personal situation: the asset is more valuable to me than to others (I need wheat in two months!); ii) speculative: I simply know better than my counterparty. iii) hedging: I suspect the average counterparty is overweight this exposure, and is willing to offer what would be a decent value to someone whose portfolio is uncorrelated with the exposure. Unless one assumes both efficient markets and homogenous investors, all three of these things are reasonable to think about, and I think successful investors do think about them routinely. If an investor does not believe herself to have special information about the “fundamental” value of a contract or commodity, she still may believe that hedging demand for a product is one-sided, and that would tilt in favor of taking the other side of that trade at the margin. Obviously, suspecting that wheat farmers need to hedge wouldn’t be sufficient motivation for buying August wheat contracts. But when choosing between a menu of imperfect investments, the existence of imbalanced hedging interest can be important information. With standardized products, that is something one can try to learn and understand.
With a bespoke product, one cannot. With a bespoke product, there is generally an initiating party (Paulson for our CDO, perhaps an industrial firm looking to hedge an idiosyncratic risk). The counterparty to a bespoke contract (e.g. an investment bank) usually knows something about the initiator and can divine something about its motivation. The counterparty to a bespoke product should generally not be anonymous. If the counterparty remains anonymous, it should at least be identified that there is an identifiable initiating counterparty. Otherwise, there would be terrible scope for tailoring products based on precise information asymmetries that the non-initiating counterparty wouldn’t suspect.
If Goldman could have met Paulson’s needs by stitching together positions in the CDS market without constructing a CDO, there would have been no issue: Those are standard markets, and participants understand that there is both speculative and hedging demand, and traders with more and less information. Traders make statistical inferences, for better and for worse.
But Goldman met Paulson’s demand for a bespoke product by creating a new counterparty and pretending the new counterparty was the initiator of the trade, not the responding to external demand for a custom product. Not knowing who is the initiator and who is the respondent is seriously harmful: market-makers and traders pay great attention even in standardized markets to where trades fall in the bid/ask spread, and adjust pricing actively based on that information. Ordinarily, someone who needs a special product that cannot be synthesized (at convenient prices) from available markets has to reveal their need, allowing potential counterparties to evaluate the source (is this counterparty hedging an industrial risk, or do they know something). That information would crucially determine the pricing and willingness of a counterparty to transact.
Goldman actively camouflaged who initiated and who was responding to Paulson’s demand for short positions in certain securities. It created a single bespoke counterparty that believed itself to be the initiator. Goldman hid from that counterparty information that it knew, and that generally any one party responding to some other party’s complex and specific demands would either learn as a matter of course or demand to be revealed. ABACUS investors thought they were in an ordinary CDO deal, initiated by longs in cooperation with a facilitating investment bank, buying an optimized portfolio in standard markets that included both speculative and hedging demand. That was not their situation at all. Their information was worse than the information an individual transactor would have purchasing a stock or in the RMBS CDS market (no specific knowledge but a decent probability distribution). And the stakes were much higher, because they were entering into a large transaction with one counterparty. If this had been a large transaction spread across many counterparties, their statistical inferences about the degree of spec/hedging interest and information asymmetry might have been accurate. In this case, they would have had to assume an almost worst case scenario to be accurate, but didn’t know that.
2) Goldman strenuously implies that “sophisticated” ABACUS investors should have known they were up against a speculator. You are right that it would be unreasonable and immaterial if, as I suggested, ABACUS investors assumed that ALL protection demand was due to uninformed hedgers. But it is terribly unreasonable for Goldman to suggest that an investor should presume that ALL protection demand is due to a speculative counterparty highly committed to his views. Basically, it’s unreasonable as I may have suggested, to apologize for investors assuming the most benign scenario. But it’s unreasonable, as Goldman suggests, to hold investors accountable for assuming the worst case counterparty, just because Goldman made it so. Sophisticated investors reasonably expected a statistical mix, and presumably offered pricing based on markets with a statistical mix. In standard markets, traders carefully modulate prices based on trade flow likely due to those with committed views. Paulson effectively managed to cheat the adverse price action that would have stolen some of his profits in standard markets by having Goldman synthesize a counterparty that used markets full of price-uncertain hedgers as benchmark prices to trade his very committed views. Even investors as shitty a ACA would have upped their requirements for protection costs if they knew that for every contract in their portfolio, their counterparty had a strong committed negative view.
Blah!
April 17th, 2010 at 10:07 pm PDT
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rootless_e — income from this deal would have been the proceeds from the collateral securities (Treasuries, presumably), modulated by the net inflow(outflow) from the CDS portfolio.
April 17th, 2010 at 10:09 pm PDT
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SRW,
Quick reaction to your general response @ 9:09 p.m.
“We can synthesize equity as easily as we synthesize RMBS in the Abacus CDO.”
I don’t agree, at least not in the sense you are claiming. Your IBM total return swap is nothing like a new equity issue. IBM in real life is not directly “liable” for the market performance of its stock once new equity has been issued. This confuses the performance of a financial claim with the performance of the firm itself. There’s no point in even having balance sheet and income statement accounting including measures of profit in such a crazy world – you simply take the market value of the stock and attribute profit back to the firm based on the change in the stock. It completely confuses actual profit earned by the firm with future expected profits capitalized by the market. You can’t pay out capitalization values from periodic earnings. And it’s not equivalent to an economic measure. It’s a market measure versus a firm measure. The market capitalizes much more than the running profit of the firm – so how can you expect the firm to pay out capitalization values from running profit values? You may well argue this is just an accounting rationalization, but there comes a point where you have to separate the measure of the firm’s performance from the measure of the market’s capitalized expectation of that performance. With the total return swap mechanism you suggest, these measures seem hopelessly confused to me.
The old/new, short/long paradigm for a new equity issue makes some intuitive sense, but it seems very rough.
On the synthetic aspect, it seems to me the salient point is that synthetic CDO’s simply allow “speculative” protection buying more naturally than cash CDO’s, given the natural cash pipeline from the original mortgage origination into the CDO. The ultimate protection buyer in that cash pipeline of course is the original mortgage issuer (i.e. the household mortgagor who is borrowing the money). With a synthetic, it is simply more obvious that the ultimate protection buyer may well be some economic entity other than the household mortgagor. It just seems naive to me to expect that the “norm” for protection motivation in the synthetic case is the same as the norm in the cash case. And one way to draw attention to the difference in norms is to highlight the necessary short side offset in the synthetic case, which is likely different in motivation from the technically short side created naturally by mortgagors.
April 17th, 2010 at 10:27 pm PDT
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steve – i was a trader for many years on different sides of the business. I can tell you that for a trader, the motivations of the counterparty are essential – but it’s YOUR job to try to figure them out. JKH’s point, i think, is that ACA sat down and discussed this stuff with Paulson!! They had pretty ample opportunities to ask. but they made assumptions instead. i’m sure you know the old saying… assume makes an “Ass” out of “u” and “me.”
anyway, i think that while often times trading, counterparty motivation may have played a role of as much as 90% significance in my decisions of if a trade was one I should do, in THIS CDO scenario, the counterparty value would have been tiny. maybe 10% of the equation. On the other hand, I think that if ACA had done the actual analysis on the underlying CDO components, that would have easily convinced them not to do the trade.
so of course counterparty motivation matters. but in this case, it’s a tiny factor, in my opinion.
also, remember, as some have already mentioned: that Paulson was not the God of Housing back then…
April 17th, 2010 at 10:42 pm PDT
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SRW,
Your discussion of standard markets, bespoke products, and initiating and responding roles is very illuminating, thanks.
It does seem to me that Goldman could put the issue of morality (and competence) directly to ASA here. The SEC brief reads as if ASA was supposed to play a meaningful functional role as the CDO manager – with expectations from other investors that it would play that role. It reads as if investors were relying more on ASA than Goldman for the types of norms you’ve described. Again, I find it impossible to fathom how ASA in its series of direct meetings and communications with Paulson did not itself unambiguously confirm the Paulson role (as per KD’s comment above). It doesn’t reduce the sleaziness of the Goldman role, but it makes the identification of ultimate responsibility (and culpability if necessary) more complicated in my view.
April 17th, 2010 at 10:47 pm PDT
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The real question seems to be that of the economic value created by CDO deals (synthetic or cash). Somehow believers in efficient markets managed to convince themselves that it is possible to have AAA-rated securities yielding more than other AAA-rated securities.
The following question is why a financial institution supported the Federal Reserve and the taxpayers is allowed to participate in originating and trading this kind of deals.
The Volcker prohibition has to be expanded beyond prop trading and into origination of anything that is not debt or equity of actual companies.
April 17th, 2010 at 10:51 pm PDT
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I guess I’m saying that Goldman had positioned themselves all along pretty cleverly for a contingency of this type of charge.
I hear they’re a clever firm in general.
April 17th, 2010 at 10:52 pm PDT
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[…] exercise came from thinking through the excellent comments to the previous post, especially those of JKH. Thanks always to interfluidity’s exceptional […]
April 18th, 2010 at 2:39 am PDT
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Yes, the abacus portfolios were held in an spv. Duh. That doesn’t mean anything. A synthetic TRS is indeed a good analogy here. When I enter into a TRS, there has to be somebody paying that total return to me. It is a ZERO SUM GAME, just like every other OTC derivative.
This is COMPLETELY different than owning a cash CDO, where there is no offsetting short position (it represents a real position in the underliers).
You can’t create new assets where none existed before. When you build a synthetic you need one side betting on failure and one side betting on success. Otherwise there is simply no market. I seriously have no idea what your point is here.
As far as the actual complaint by the SEC, does anybody understand what rule Goldman is alleged to have violated? As I understand it, one of the two longs was responsible for deciding on the portfolio. The complaint certainly cannot be that Goldman didn’t tell the longs who it sold the short to (middlemen do not disclose under current market practice).
April 18th, 2010 at 2:39 am PDT
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SRW – you’re exactly and importantly right in your analysis of the “cash vs synthetic” distinction – particularly when it comes to the somewhat counter-intuitive case of a corporate issuing equity. Your issue with GS’s behaviour in this situation arises, I think, somewhere in the nexus of what JKH calls the “discussion of standard markets, bespoke products, and initiating and responding roles”. You seemed particularly concerned with the nature of “speculation” and “hedging” and what this means for decision-making in financial. I’ve found in practice that these are very slippery words and dangerous ground for making judgements about people’s behaviour.
You seem to believe that financial arrangements can be divided between “bespoke” and “standard” markets. As you know, all OTC derivatives, including CDS, are bilateral contracts, which are generically of a standard form, but do frequently differ in important respects. In this sense, each OTC derivative is a “one-off” (this is why it’s so difficult to cancel/unwind the trillions of these things we have sitting around in banks’ books). I’d argue that CDO structures are similarly one-off, but also, around the time that this deal was getting put together, sufficiently standardized that no one would be suprised or confused by the structure or roles of the various agents involved. So even this one is a heck of a lot less “bespoke” than one might imagine.
I guess you’re also saying that the complexity of the structure, particularly the role of the CDO “manager”, puts it in the class of structures or legal mechanisms that allow one group of financial market participants (“speculators”) to take advantage of another, historically separated group (ie. “investors”, esp pension funds). At the risk of putting words in your mouth, you’re saying that because this mechanism bridges these two worlds, GS has some obligation to announce to the innocent lambs in the investor world that this isn’t a normal pool of mortgage-backed securities, but one that’s been picked out by a single lone-wolf genius hedge-fund manager who thinks they’re a good sell at this price. This point has some merit, but I think sadly the time for this kind of objection passed about twenty years ago. There is little market segmentation left in the world, and the story of derivative products is one of the elimination of barriers between different pockets of capital. The problem of innocent “investors” facing clever “speculators” exists everywhere. I’d suggest one useful analogy in the cash world is the activity of long-short equity books, merger arb, and other equity strategies in which one player has a large book or shorts they’re trying to put on. Banks have built equity execution platforms that face all kinds of investors (including retail and pension funds) and blow these positions out to the world at large incredibly efficently and without any mention that they’re shorts that the world’s greatest equity trader wants to put on. This kind of breaking down of market segmentation happens everywhere, all the time in one form or another, through both legal and technological innovations.
It’s also worth keeping in mind that the form of this transaction made it pretty clear what it was: a complex financial arrangement with good yield to compensate you for the incremental complexity and opacity. If you’d like to say “but the arranger needs to tell the buyer that there’s a speculative short on the other side”, you need to get a little more specific about how you’d do that. The person that wants a short can add a few layers to this kind of arrangement to get an actual holder of actual RMBS somewhere in between, if that’d better fit whatever rules you’d come up with. I’m not sure how you identify the sheep and the wolves in any particularly effective way. The ground rules used to be that if you were an institiutional investor, you were happy to run with the wolves. But if you can come up with a better set of labels and code of conduct, now’s certainly the time for it.
April 18th, 2010 at 2:56 am PDT
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Joe — I don’t want to pretend we can draw very sharp distinctions between speculation and hedging. All I want to do is to suggest that, for products for which there are reasonably standardized markets and a decent volume of exchange, investors (like market makers, but with less fine-grained information) draw inferences about the information content of the market and the degree to which they can trade on fair or advantageous terms. We can dispense with line drawing about what is and isn’t “bespoke”, and just suggest that as trade volume in the universe of possible instruments diminishes, our ability to draw such inferences is hindered, and investors trading in unusual or unique instruments need to be especially wary of their own information relative to that of their counterparty.
Usually the initiator of a trade in a unique instrument determined its form based on its own information and needs. So if one is going to be the reactive counterparty to a particularly complex trade — the liquidity provider, to use the right term — one needs to know something about the liquidity demander, or else charge a very steep premium to cover adverse selection costs. Liquidity providers on standard exchanges do just this — they pay very close attention to patterns of order flow, and “jump” on observed flow imbalance, because the behavior suggests that some liquidity demander may know something. (Perhaps the demander is mistaken, but a liquidity provider would lose on average taking that chance, and in any case would accumulate unwanted inventory.)
Really what I am saying is that liquidity provision for rare or unique trades is much more hazardous than ordinary trading by liquidity demanders. What Goldman did (and should not be permitted to do) was to create a liquidity provider for Paulson that imagined itself to be simply a trader of standard products. There are some ironies here — in absolute dollar terms, the ABACUS CDO — benefited from having Paulson to trade with, since otherwise its trading could have moved prices against it some. But the CDO would not have traded at all, had it not been for Paulson’s need for a liquid market for the protection he wanted to buy. ABACUS investors did not know that their “efficient trades” were due to having been constructed precisely to supply liquidity on terms that a knowledgeable liquidity provider would never have agreed to.
Ultimately, the foul was in the circumstances under which the CDO was constituted. Goldman itself was unwilling to provide Paulson the liquidity he wanted for the trades he wanted. (He could of course have purchased the same protection without the CDO, but prices would have moved against him, using Goldman or any other firm for a market maker). So Goldman found another party “willing” to provide the liquidity unwittingly.
As far as rules are concerned, I think it’s pretty simple. The arranger and marketer of a new investment vehicle must have a fiduciary obligation to the new investors, must disclose any conflict of interest, and information it has regarding counterparties taking opposite views with whom the vehicle might trade. Ordinarily, I think (hope?) that structured credits are arranged without the knowledge of a short counterparty, and new vehicles demand liquidity from the market and pay a spread, like other investors. I have nothing against vehicles being created to offer liquidity to a prior liquidity demander by taking the opposite side of his trades, but in my view, that must be a first-order disclosable circumstance.
You are right, of course, that any set of rules will be gamed. Rules are never sufficient. I think Goldman is in trouble over this, even though legally they may squeak by. Regardless of the laws and Goldman’s disclaimers, the manner in which it behaved just “doesn’t pass the smell test”. I think Goldman-ites have come to imagine that practices that are colorably legal are sufficiently ethical for an “aggressive and competitive” firm. I think they may be painfully disabused of that, and not without justice.
BTW, I have little sympathy for ACA or IKB or whomever. I think they were terrible investors, irrespective of Goldman’s nondisclosures. But I could not do business with a Goldman Sachs that behaves as the firm currently behaves, other than in a mechanical sense. I would not permit them any discretion over the use of funds in their care, I would not trust the quality of any marketing of any investment vehicle they offer, I would presume strategic biases and omissions in any statement I received from them. I would not knowingly invest in them or lend to them. I think I will soon be less lonesome in these views (and I don’t think Goldman is uniquely bad). Ulimately I share your pessimism about rules, and I think it implies a different organization of the investing business around smaller, more relationship-centered firms. Vast organizations willing to play any clever trick that can slip past the law man are just too much quicksand to deal with.
p.s. I’ve written a new post on the GS/Abacus thing, which took off from my conversation with JKH and has clearly influenced this response.
April 18th, 2010 at 3:39 am PDT
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KD — I’m with you on most of what you say. It’s a particularly interesting question about Paulson, to what degree the ACA types did/would have/should have known anything about him (and whether he ever misrepresented his role).
I think one of the worst influences of “efficient markets” theory was to persuade people that one doesn’t have to think about counterparties, that there is just the one, God-like market. I don’t think there are many successful financial investors who don’t think about who they are trading with/against.
April 18th, 2010 at 3:42 am PDT
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JKH — I think I agree with your take on the cash/synthetic thing. A way to look at it is that the existence of synthetics reduces short-sale constraints (which are strong in cash-only bond markets).
The ABACUS CDO itself would have performed almost identically if it had purchased cash RMBS rather than synthesizing the exposure out of Treasuries and CDS. (The argument that the malperformance of the CDO was in any way related to its syntheticness is BS, IMHO.) But the existence of the CDS on the component instruments implied that they were shortable instruments, where bonds for which entering a CDS position would be difficult are largely immune from speculative shorts. That doesn’t mean that they are any safer — on the contrary things that can’t be shorted can get overpriced without check. But it does mean that the person you are buying the thing from actually owned it — their pessimism (if speculation is the motivation for the sale) was preceded by optimism — and you are not playing against certain classes of investors who only would speculate via liquid derivatives.
April 18th, 2010 at 3:49 am PDT
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[…] needs to “reform or die.” (Interfluidity, ibid also Felix […]
April 18th, 2010 at 5:46 am PDT
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“rootless_e — income from this deal would have been the proceeds from the collateral securities (Treasuries, presumably), modulated by the net inflow(outflow) from the CDS portfolio.”
So the reason that anticipated income was higher than proceeds from collateral securities, which would have been safe, is that there is a casino bet on the performance of the reference securities. My point is that the fact that someone was betting on the failure of those securities is very much upfront – which is why IKB lists CDS exposure in their annual report.
This was an open bet that the ratings agencies and ACA had correctly evaluated the risk and that probabilities would win. IKB and ACA presumably thought that the risk evaluations were correct and so whoever GS had found to take the other side of the bet was a chicken to be plucked of fat premiums. This deal is based on the same principle as the Nigerian bank scams, the mark thinks that the other side is the mark.
April 18th, 2010 at 7:37 am PDT
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Facts:
1. CDO’s add value purely through diversification; if a CDO investor knew that underlying reference securities were not “diversified”, he would pay less for or shun the issue.
2. By letting Paulson pick the reference securities, ACA effectively canceled the value created through diversification.
3. GS sold a non-diversified CDO to investors while representing it as diversified, even though they knew, given the portfolio selection process was skewed in favor of the counterparty’s interest.
———————————–
Someone asked above if I would buy a mutual fund if I knew the portfolio was constructed by someone short the underlying securities. Of course. Some of the mutual fund’s benefits come from diversification, and some come from “alpha” — divergence in views over potential fair value for the INDIVIDUAL securities.
In contrast, I would argue that ALL of a CDO’s value arises from diversification, none from potential mis-pricing of individual reference securities. Therefore a CDO investor is COUNTING on buying a diversified portfolio constructed almost “blindly” with regards to price arbitrage potential. The seller of this portfolio — effectively Paulson — jammed the portfolio with securities it felt had the potential for significant price arbitrage. One can conclude from that, fairly easily, that the portfolio was not diversified, at least not in a way that the CDO investor could fairly expect. Goldman, in order to market this security, HAD to refrain from stating that fact, otherwise the deal was DOA.
Was Goldman’s failure to disclose the CDO’s lack of diversification a violation of securities law? No idea. In fact, I don’t think anyone really knows, because the blanks in securities law are filled in by the courts, and we cannot know how the court will fill in this one.
Lastly, I would point out that those who argue IKB should have known it was “playing with the big boys” misunderstand, I think, the nature of a CDO. If Paulson felt housing was going down the tubes and IKB was blind to that fact, that view holds true — it takes two views to make a market, and IKB had the losing one. If IKB was WILLING to take the risk of a housing implosion ONLY in exchange for diversification, then IKB, even while playing with the “big boys”, was defrauded.
April 18th, 2010 at 10:20 am PDT
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David, you’re missing the most troublesome aspect of those facts. Their act of selecting toxic mortgage candidates effectively increased demand for the mortgages that would default. Before now, the subprime fiasco has been explained by exuberance. This was not exuberance… they basically pumped up housing in sand states so they could get short!
April 18th, 2010 at 2:01 pm PDT
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[…] Goldman-plated excuses – via Interfluidity – My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. Basically, the SEC claims that Goldman failed to disclose a conflict of interest in a deal the firm arranged, that perhaps Goldman even misdirected and misimplied and failed to correct impressions that were untrue but helpful in getting the deal done. If that’s the worst the SEC could dig up, I thought, there’s way too much that’s legal. Had you asked me, early Friday afternoon, what would happen, I would have pointed to the “global settlement” seven years ago. Then as now, investment banks were caught fibbing to keep the deal flow going (then via equity analysts who hyped stocks they privately did not admire). The settlement got a lot of press, the banks were slapped with fines that sounded big but didn’t matter, promises were made about “chinese walls” and stuff, nothing much changed. […]
April 18th, 2010 at 2:47 pm PDT
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[…] a stand-out post, Steve Waldman questions the role of shorting in CDOs overall, arguing that CDOs are more akin to […]
April 19th, 2010 at 3:51 am PDT
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A wonderful and very elucidating post!
By the way “just as we all knowingly and happily overpay for insurance on our homes.” Well, I didn’t know that!
April 19th, 2010 at 5:22 am PDT
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Excellent post. Another “tell” on Goldman’s ethics (or lack thereof).
Regarding “reform or die,” however, I think Goldman’s response will be to spin and wriggle its way of trouble and right back into its god-given position, which is “wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money” (Matt Taibbi of “Rolling Stone”).
April 19th, 2010 at 7:14 am PDT
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Goldmans defense:
“Goldman argues that it was common practice not to disclose to investors – which in this case were just ACA and the German bank IKB – who would be taking a short position on a CDO. In the bank’s view, it would have been a breach of client confidentiality to reveal that Paulson & Co intended to short the CDO.”
http://www.ft.com/cms/s/0/59e8b69e-4b3c-11df-a7ff-00144feab49a.html
April 19th, 2010 at 8:39 am PDT
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[…] who, at their most vulnerable, find the custodians of their life savings as either crooks or suckers for the bankster […]
April 19th, 2010 at 12:53 pm PDT
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[…] fully aware how the banks serve their variety of clients with their various point of views. Enter Steve Waldman (my emphasis added): Goldman could, quite ethically, have acted as a broker. Had there been some […]
April 19th, 2010 at 5:18 pm PDT
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[…] And Leonard recommends Steve Waldman with this: […]
April 20th, 2010 at 2:24 am PDT
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There seem to be a material misunderstanding (pun intended) of what the charges against GS are. The talks about what synthetic CDOs are and what the players (GS, ACA, IKB, Tourre) needed to have understood miss them entirely. The charges against GS are (1)it lied when it represented to potential investors that ACA was the portfolio selection agent; ACA/Paulson WERE the portfolio selection agents and that much was acknowledged in their internal email cited by the SEC. And (2) GS is at least wilfully negligent when it failed to correct the misimpressions of a client/investor (ACA)that Paulson was an equity investor, even as it encouraged that misimpression.
The first charge seems clear, if anything involving lawyers can be so characterized. But the second one is a little dicey. The charge sought to show that GS knew of the client’s misimpressions. But does GS owe the basic professional service of ensuring that clients are fully and properly informed? You see, I don’t feed in the fetid waters of subprime mortgages and incestuous security bets so I wouldn’t know. But imagine what will happen to our economic system if you could no longer trust your consultants or for your doctor to promptly correct your misimpression of a tumor for a headache. That expectation seem to come standard with professional services. Just my thoughts…
April 20th, 2010 at 3:38 pm PDT
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A wonderful and very elucidating post!
By the way “just as we all knowingly and happily overpay for insurance on our homes.” Well, I didn’t know that!
April 20th, 2010 at 7:08 pm PDT
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[…] was a short side, and hence there was no need to disclose Paulson’s involvement. Waldman completely dismantles this argument, starting with a point so simple that most of us missed it: a CDO is just a way of repackaging […]
April 20th, 2010 at 10:06 pm PDT
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Whilst I hate to defend GS, I think it matters that this was a synthetic mezzanine ABS CDO rather than a standard synthetic CDO. In a mainstream synthetic CDO the reference portfolio consists of large corporate names or highly liquid ABS shelf issuances, the CDS of which can be readily sourced in fairly liquid markets. Hence in these transactions the CDO bond and equity investors who are long the reference portfolio can reasonably believe that the short CDS positions have been sourced from an array of investors with an array of motivations (hedging, speculation or whatever).
However it was well known that even at the height of the credit bubble the CDS of mezzanine ABS tranches were almost completely illiquid. It should have been obvious to the long investors in the Abacus deal that the short interest in the reference portfolio could not have been widely sourced. Rather it had to come from a single or small number of investors who had approached the deal on a portfolio basis.
April 21st, 2010 at 12:46 am PDT
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JLF — I’m not sure I agree. The trouble with mezzanine tranches was that no one wanted to be long them, but there they were, no? By necessity, people were stuck with them as a byproduct of securitizations, and no one would sell protection, because no one wanted that exposure. That is, there was very strong demand for hedging, and few willing hedgers.
That’s precisely the problem synthetic CDOs were invented to solve, no? The basic idea of a CDO is that it is more sensible to be an insurance company with a diversified portfolio of policies than to insure a few wooden houses. Mezzanine synth CDO investors would have thought of themselves as insurers of a diversified portfolio of shacks, about which the people on the other side were legitimately nervous, but who certainly didn’t want to see the shacks burn and were willing to pay up a bit for some protection from that eventuality.
In other words, the illiquidity in the CDS market traditionally would have been due to very few protection writers, and synthetic CDOs (to the degree that mezz tranches like wooden noncolocated wooden shacks burned uncorrelated) were a very effective means of overcoming that illiquidity by synthsizing a safer and more efficient protection writer. But that protection writer would not have expected the protection buyers to be specs. On the contrary, they would have thought they were meeting one of the market’s most acute hedging needs. It was on the long side that CDO investors were taking, not on the short side, that investors would expect a relatively small number of investors.
Am I missing something?
April 21st, 2010 at 1:43 am PDT
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Regarding “reform or die,” I guess it depends on the definition of “reform” and “die.” Sure, there will be “pretend reform,” and perhaps a witch burning, but that’s probably all. It’s pretty much standard operating procedure. The politicians will get to point to the “reform” they passed, the “big” fine they imposed, and perhaps some perp-walk footage on TV. Goldman will get to get back to doing god’s work, that being jamming its blood funnel down throats and up backsides. Nothing will really change. Regarding the “die” part: Goldman doesn’t die, Goldman gets bailed out — with your money, with which it earns a massive return, which it promptly pays out to itself and its friends in Washington. Wash, rinse, repeat.
April 21st, 2010 at 2:17 am PDT
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Steve – you make an interesting point but from what I saw the vast majority of long interest in ABS mezz tranches was unhedged and there was very little appetite for hedging until it was already too late. Everyone had swallowed the ABS rating stability mantra so completely that most investors felt even single notch downgrades were farfetched. The structuring challenge in these CDOs was very rarely on the long side but rather came in sourcing the short interest and assembling a wide range of protection buyers for a mezz ABS CDO would have been near impossible in practical terms. Given the nature of the reference portfolio in Abacus I’d contend that any competent long investor should have known that there would be a single party on the short side (or at most a very small number). Even if that were known, I’d grant that the motivation of the short could have been hedging or naked speculation though whenever I came across these trades I assumed the latter.
From what I saw of IKB I’d wager they would not have cared about the short motivation. It’s easy to see them now as dumb roadkill but they were a major (and highly arrogant) player in the CDO space who thought that the diversification in these portfolios had essentially removed risk. Of course the portfolio correlation proved to be near 1 so the diversification was phony as many in the market (like Paulson) saw at the time.
From my perspective synthetic CDOs were largely ratings arbitrage vehicles rather than anything designed to solve a market problem per se. They allowed investors with rating constraints to achieve higher yields than anything available in the non-structured space, so say a junior ‘AAA’-rated ABS CDO piece might yield 120bps when prime AAA RMBS was yielding 20bps and GE 10bps. This was largely achieved through negative selection in the reference portfolio, the whole idea being to load up with as much CDS yield as possible at the prescribed rating level. The reference portfolios then always tended towards the ‘yieldy’ and hence the lowest quality credits in both the ABS and corporate spaces. So, while it’s a little bit of a chicken and egg debate, I see synthetic CDOs as primarily generated by long investors hunting highly rated, high yielding paper rather than short demand.
April 21st, 2010 at 3:43 am PDT
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JLF — I suspect you have a good deal more to go on in judging the tone of the market in those days than I do, so I’ll defer to your judgement.
But, I’m more sneaky than humble — some of my deference comes because a lot of what you say confirms my suspicions.
I don’t want to get into a gossipfest about the motivations of ACA and IKB (and ABN/AMRO) in particular, or the character of their employees. But speaking abstractly, it strikes me that you can divide CDO investors into three groups: 1) the archetypical “reasonable investor”; 2) the regulatory arbitrageur; and 3) the bonus-seeking corrupt agent. The categories aren’t mutually exclusive: I’m sure that most real investors had a bit of all three in them. But the story we tell to make sense of the behavior surrounding ABACUS will depend on how we characterize the firms.
I’ll state first, that as a matter of ethics, and I hope law, in judging Goldman’s behavior, we have to assume the “reasonable investor” story, even if its counterfactual. (And again, I prefer we not try to adjudicate those facts.) All of Goldman’s marketing, both directly with respect to the deal and I suspect indirectly in white papers and general communiquées would have pretended that the investors belonged to category (1). [yes, with some (2)-lite which means they pointed out the “balance-sheet efficiencies”, but didn’t hint that there was the possibility that the state would actually take the downside. doesn’t change our story.] Goldman should be judged by whether it treated a hypothetical reasonable investor acceptably, not by the corruption of the counterparties that took the deal. You argue that for this kind of deal, a reasonable investor might have been expected to know that for this particular kind of CDO, the short interest would be speculative. I think that’s setting too high a bar, given the general rationale for the economics of CDOs, and would argue that the period during which this deal took place was a period of changes, when, as you day, long demand began to drive the CDO market rather than hedging demand. I’d argue that reasonable investors needed markers that their previous experience of the “synthetic CDO” market was becoming obsolete due to changes in the market, and that the chain of inferences you suggest people should have made is more obvious ex post than it would have been at the time, so that the presumption of competence is not enough to absolve Goldman of its requirement to disclose. Reasonable people can differ about this, absent evidence of what CDO investors generally did or did not understand at the time, and maybe Goldman and the SEC will look for evidence of what market participants did and did not think. But, if you concede reasonable people can differ, and if you think everybody should have known, both of those suggest that Goldman should have erred on the side of disclosure, and would have had little to lose by doing so, since everybody knew.
If we imagine the parties — Goldman, ACA, IKB, ABN/AMRO to be corrupt, that is, to either have been intentionally building up tail risk they understood on the theory that when the tail bites, everyone will have done it and no one will be blamed, or to have involved managers screwing their own firms downstream in pursuit of present bonuses, you can explain the nondisclosure as in the mutual interest of all time-zero, private parties: non-disclosure could have been mutually agreed to give cover to a scam everyone involved in the deal was profiting from. If you tell this kind of story, then Goldman can’t be accused of hiding stuff from investors (everyone knew but didn’t want it on the record). But it hardly absolves Goldman. It just buries in manure all parties to the deal.
April 21st, 2010 at 5:56 am PDT
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re rootless_e’s comment: “IKB were grossly negligent and their management should not have been managing millions of Euros of other people’s money because they were clearly unqualified”
Totally. Anyone and everyone in the structured credit markets 5 years ago knew these guys (and a few other parochial domestic European banks) were the suckers at the table. They had no clue, were paid badly but the sell-side bankers made them feel like rock-stars (‘you’re the man’…’junkets to our structured credit conf yacht in Barcelona’…’dinner with our CEO’…etc… ‘just sign here…’ ‘…its AAA what’s the worst that can happen?…’) Totally corrupt imo. IKB a ‘sophisticated investor’…Ich don’t think so…
Sorry my point is – I don’t know if any of this crossed into illegality or not, I’m no lawyer – that none of the participants comes out of this looking particularly good…
April 21st, 2010 at 8:32 am PDT
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Will someone explain to me how Paulson could own CDS on the syn CDO without there being a long?
The SEC states that there were multiple meetings between Paulson, Goldman and ACA. How could a “sophisticated investor” in 2007 not know that Paulson was shorting? The SEC has testimony that Paulson not only said he was shorting, but repeatedly discussed the characteristics of the reference securities they were trying to short.
April 21st, 2010 at 8:45 am PDT
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I sure don’t mean to absolve GS and I think the post above by ‘Yopele’ nicely summarises their misdeeds. I think they’ll lose the case based on what I’ve seen so far.
However, it’s worth remembering the synthetic CDO market was largely a regulatory and ratings arbitrage game and to borrow your phrase the manure was thick on the ground. The legitimate demand (‘reasonable investors’ let’s say) for structured leveraged credit exposure was not significant and what there was, was mostly in the cash CDO space. Pretty much everyone in the synthetic CDO market was compromised and so I find the ethical debate a little unrepresentative of the market as it was at the time.
As regards disclosure of the short interest this was never market practice so, although in a more sane market I’d concede it should have been standard, I can’t fault GS on this score. On private trades like Abacus it was often tough to figure out who the long investors were and I know of cases where the short interest didn’t know or care.
Not to go too far off topic but the larger scandal has to be that a whole booming CDO industry was allowed to develop with the primary purpose of undermining and evading the structures designed to safeguard investors and ultimately the taxpayer (regulatory/economic capital requirements and rating investment constraints). This wasn’t a secret – you just had to pick up any CDO pitchbook from any major investment bank to figure it out.
Fab Fab Tourre and GS and their pretty typically grimy misdeeds strikes me as a sideshow that will probably distract from the larger picture of dangerously under/misregulated financial markets.
April 21st, 2010 at 8:57 am PDT
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May I offer you a couple of different tweet-views on the Goldman Sachs affaire!
Goldman’s ABACUS 2007-AC1: The whole truth and nothing but the inconvenient truth! http://bit.ly/acaRfo
The lover’s spat between Goldman Sachs and “sophisticated investors” is not the real problem! http://bit.ly/95stIo
And now, is it time for some “Razzle dazzle ’em” http://bit.ly/b5b5ob
We can’t shame enough the irresponsible silent experts and the plain lousy regulators http://bit.ly/aXSYyu
April 21st, 2010 at 10:19 am PDT
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Isn’t it possible that ACA WAS selecting the best portfolio possible at then-prevailing prices? Doesn’t it seem likely that somebody coming forward with an axe to buy protection on a basket of securities would present a more attractive option in terms of pricing than ACA having to go to the market for each security separately, paying commission (indirectly) on each trade and being subject to the whim of the market?
ACA probably looked at this as a great opportunity – they had certainty of execution/pricing, and probably favorable levels given Paulson’s axe. They obviously did not do much work (or at least their analysis was poor) on the securities in any CDO they issued given the horrible performance on these things, so security selection was not exactly a huge sticking point for them anyway. And even if they saw these securities as marginally weaker, the ability to kick out what they perceived to be weaker CDS and the relatively better pricing from a block protection buyer probably compensated them for that in their eyes. Bottom line, when somebody came to them willing to pay what they perceived to be a better than market price for a basket and guaranteed quick execution, they probably jumped at the chance.
In the end, there does need to be somebody on the other side of all of those CDS trades. Whether it is a single party or several parties was not relevant in this case, as the counterparty had no direct influence on the PERFORMANCE of those securities nor did the counterparty have any better information on those securities than did the sellers of protection. This was just one investor taking the opposite view of others. That’s what makes a market.
Let’s not cry about it and instead focus on the real core of the problem: every player along the line was MASSIVELY overlevered in both the traditional sense and through derivatives that regulators repeatedly turned a blind eye to. Ignoring everything else, if institutions were properly regulated just in terms of leverage (accounting for implicit leverage of derivatives) and risk, we would not be where we are today. There would still be losses and failures, but we would not be in the potential systemic meltdown state that we have been for the last two years.
And the argument of financial products being too complex to regulate is complete hogwash – biotechnology and pharmaceuticals are pretty complex, yet we manage to do a pretty decent job of regulating that industry. We need not stymie financial innovation. We just need a regulatory body that isn’t so heavily influenced by politics (ie, Congress allowing Fannie and Freddie to become ticking time bombs) and the institutions they regulate (the reason that it has taken a meltdown for people to even start talking about derivative regulation) to actually regulate the market instead of serving as arm candy for elected officials as they court voters and campaign contributors.
April 21st, 2010 at 10:34 am PDT
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A few quick Q’s:
1.Was the Abacus 2–7 AC1 raising Cash from Investors for the purchase of CDO’s, or CDS?
2.Was ACA the primary equity investor in Abacus, along with IKB, or wer therw others?
3.Was ACA intending to re-sell (or lay off) the ‘long’ position?
4.Was this offering exempt from ’33 Act registration as a Private Placement (Sec. 4(1), Reg D, or another exemption, and were hter major firm legal 10b-5 opinions that confirmed the adequacy of disclosure
April 21st, 2010 at 10:51 am PDT
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Usually good thinking, but this is crap analysis.
April 21st, 2010 at 2:07 pm PDT
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[…] Must read regarding the Goldman issue. […]
April 22nd, 2010 at 2:18 am PDT
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SRW It seems after reading the first 7 or 8 reply’s to your post that your readers either didn’t understand what you said or are Goldman Disciples seeking to muddy the water of logical discourse or need think a little more.
Also When someones buys a Stock they are buying a share in a financial entity whose existence is regulated by a broad array of securities laws and regulations which enforce disclosures on so many levels. So many of the rebuttal arguments here seem to disregard this fact. While the untamed world of financial innovation has stepped outside of such regulations. Caveat Emptor
April 22nd, 2010 at 5:16 am PDT
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[…] here to see the original: interfluidity » Goldman-plated excuses If you enjoyed this article please consider sharing […]
April 22nd, 2010 at 11:44 am PDT
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[…] Source […]
April 22nd, 2010 at 7:00 pm PDT
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Alas, after reading most of the posts it seemed like sane heads were prevailing.
RAL, I am sure your heart is in the right place, but having worked in the CDO biz for the past 15 years, hate to say it, but you’re wrong on this one. I am no GS apologist. That said this is very cut and dry. If you don’t believe me, ask a friend who has experience in structured products and CDOs to explain the deal model. These things are *not* stocks.
April 22nd, 2010 at 10:18 pm PDT
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See the following blog for a clear explanation of the Goldman / SEC case:
http://streetwiseprofessor.com/?p=3674
April 24th, 2010 at 12:37 am PDT
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[…] Goldman Sachs are about two articles by Steve Randy Waldman clarify the case, even to the layman; Goldman-plated excuses; L’affair Goldman in price/information terms. Waldman blogs at […]
April 25th, 2010 at 9:45 am PDT
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THE GOLDMAN DEFENSE: All the counterparties in our CDO/CDS deals knew the risks involved.
WRONG!: The American taxpayer who had to bail you out along with the entire banking system is the biggest counterparty to all these deals and the taxpayer had no idea of what was going on, much less the risks involved.
FURTHERMORE: If all the counterparties, as you claim, knew the risks involved, that means you, Goldman Sachs, knew the risks involved and therefore should have recognized the possibility and consequences of AIG not being able to make good on their CDS obligations. Which means the one counterparty that wasn’t informed of the risks—the taxpayer—should not have been liable for the $13 billion in AIG counterparty bailout money you received and promptly distributed among yourselves as “profits”.
FURTHER STILL: If, as you, Goldman Sachs, claim, that all counterparties were aware of the risks involved, then you, Goldman Sachs, should have been allowed to fail.
THE GOLDMAN COUNTER DEFENSE: We were never at risk of going under.
WRONG!: If that’s true, then you should repay the taxpayer—the only counterparty who wasn’t privy to the risks—the $13 billion in AIG counterparty money you distributed among yourselves as “profits”.
CONCLUSION: Return the $13 billion you STOLE from the American taxpayer as penalty.
April 26th, 2010 at 3:20 pm PDT
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ACE you did not understand my post as well . . . funny. You seem to post this sentence as a Rebuttal when it was one of the points I was making “These things are *not* stocks.”
April 27th, 2010 at 10:08 pm PDT
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Outstanding post.
These are complex investments, but I’m inclined to agree with Yopele’s comments which highlight the core issues here in very simple terms.
Securities fraud induces investors to make decisions on the basis of false information. The flip book (thanks for that link!) notes that ACA is the portfolio selection manager, that it will earn fees for selecting the portfolio, and that its fee structure gives it an incentive to avoid losses. That certainly conveys the impression that the portfolio was chosen by an entity which sought to maximize the portfolio performance, or, to speak loosely, which was on the “long” side of the deal. The strength of the SEC allegation is that the financial interest of the person or persons who chose the portfolio was misrepresented, and that this fact was material. It doesn’t matter if ACA or others had poor judgment. It doesn’t matter whether you or I would buy a mutual fund even if the portfolio was chosen by shorts. We have to be told.
Elsewhere, the flip book has boilerplate that says GS may have material nonpublic information it is not disclosing, but I’m not sure if that will be enough to sustain their defense.
April 27th, 2010 at 10:15 pm PDT
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There is a distinction between acts of omission and explicit acts of misrepresentation that may be important for the outcome.
If the allegation is only that there were acts of omission, then I think the SEC has a tougher burden. The defense goes:
“So I didn’t tell you there was a short, but every sophisticated investor is supposed to know that there is someone on the other side of every trade who may have a different market view. I also didn’t tell you that the earth is round and that there is no Santa Claus. What’s the big deal? Sophisticated investors are supposed to know these things.”
But note that the flip book states:
“The Portfolio Selection Agent has selected a target granular Reference Portfolio.”
It doesn’t say that the agent merely approved a portfolio selected by a short betting against the deal. Did ACA make any changes to the reference portfolio in order to improve it? If not, or if their changes were not significant, how can it be said that they “selected” the reference? Why would they be paid a portfolio selection fee if they didn’t select it?
The flip book also quotes or presents, with disclaimers, information about ACA’s investment philosophy and asset selection process. It gives the impression that the reference obligations were identified and chosen by an agent whose interests and incentives were aligned with those of potential investors.
It’s much easier to defend against a charge of omitting something that investors are supposed to know. If an allegation of explicit misrepresentation can be sustained, the defense is more difficult.
April 28th, 2010 at 5:37 am PDT
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[…] Goldman-plated excuses […]
April 29th, 2010 at 5:58 am PDT
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