On Friday, Goldman published a letter called Goldman Sachs: Risk Management and the Residential Mortgage Market . Here’s a bit of it:

In a “synthetic” CDO, two parties enter into a derivative transaction, which references particular assets. By the very nature of a synthetic CDO, one counterparty must be long the risk (i.e., hoping to benefit from an increase in the value of the referenced assets), and the other counterparty must be short the risk (i.e., hoping to benefit from a decrease in the value of the referenced assets).

I have made this point before, but I will bore with repetition. Both in theory and in practice, there need be no identifiable party “hoping to benefit from a decrease in the value of the referenced assets”. Historically, in the vast majority of deals, there was no such party. Does anybody wish to dispute this as a factual matter? Mr. Blankfein?

Synthetic CDOs began as a tool for balance sheet management by banks. In these deals, a bank issues a synthetic CDO whose reference portfolio is composed of debt that the bank actually holds. The bank retains the first-loss “equity” tranche, but sells mezzanine and senior tranches. It may or may not retain the risk of the “super senior” tranches.

Banks derive two advantages from this arrangement:

1. They limit losses with respect to their loan portfolio. When all senior tranches have been sold away, banks total exposure to loan losses is limited to the size of the first-loss tranche, usually a very small fraction of the total assets. It is as if they have bought insurance on their loan portfolio, but the policy includes a small deductible. When banks retain the risk of “super senior” tranches, the structure becomes analogous to an insurance policy with a small deductible and a lifetime cap that is less than the total value of the loans. In either case, banks effectively lay off some of the risk of their porfolio.

2. Banks don’t need to hold regulatory capital against debt that is insured by a CDO with sufficient collateral to guarantee that insured losses will actually be covered. If investors in a CDO require a smaller premium than a bank pays to holders of regulatory capital, the bank profits by shifting credit risk to the structure (either by redeeming excess capital or, more likely, by using the capital to make new loans). This is called “regulatory capital arbitrage”.

As long as the yield investors demand is not too high, banks gain from issuing synthetic CDOs. If investors and rating agencies pay more attention to the correlation structure of portfolios than the characteristics of the underlying debt, the ability to cheaply lay off risk to CDOs might encourage banks to make riskier loans than they otherwise would. Like a John Paulson, banks doing these deals would try to cram the riskiest debt they could into reference portfolios. (Rating agencies are said to be particularly attentive to the debt selection process in bank balance sheet deals.) But in no sense do banks, the short counterparty, hope the deals go bad. Their best case scenario by a long shot is that every penny of debt gets paid, so that they earn a good yield on the equity tranche.

During the 2000s, for a lot of familiar reasons, AAA debt with a yield premium to Treasuries could be sold very easily, so entrepreneurs began structuring synthetic CDO deals based on debt they did not actually hold. In these deals, arrangers sold credit protection to investment banks, who may then have been economically short the credit, depending on how they were initially positioned. If investment banks retained those unhedged short positions, then there would, as Goldman alleges, have been a party “hoping to benefit from a decrease in the value of the referenced assets”. But investment banks were market makers and underwriters for these deals; they were not typically speculative counterparties. If you don’t believe me, here’s Goldman:

Goldman Sachs did not engage in some type of massive “bet” against our clients. The risk management of the firm’s exposures and the activities of our clients dictated the firm’s overall actions, not any view of what might or might not happen to any security or market…We maintained appropriately high standards with regard to client selection, suitability and disclosure as a market maker and underwriter. As a market maker in the mortgage market, we are primarily engaged in the business of assisting clients in executing their desired transactions. As an underwriter, the firm is expected to assist the issuer in providing an offering document to investors that discloses all material information relevant to the offering.

A market maker takes reactive positions dictated by customers who seek liquidity. The essence of market-making is accepting a risk that one might not otherwise choose in exchange for a fee or a spread. Since another party forces ones positions, and that other party might know something that the market maker does not, market makers usually strive to avoid carrying “inventory”, risk that accumulates as a byproduct of taking the other side of customer trades. The business of market-making is the art of hedging, of laying off risk forced onto the market maker by her customers. For large, complex positions, it is rarely possible for a market maker to find a single party to take the other side after it has assumed the risk of a client-initiated bet. [1] The market maker’s expertise is decomposing risk forced upon it by clients into smaller, more easily marketed positions, and neutralizing that risk via arms-length exchanges.

In synthetic CDO deals prior to 2006, the investment banks that served as market makers and took the initial short position on the CDO credit usually strove to be neutral or long the deals. They did as market makers do, and laid off their initial exposure by hedging, statically when possible, dynamically when necessary. Investment banks also frequently went long the deals they issued by retaining exposure to the super senior tranches. Out there, somewhere in the world, there may have been parties that stood to gain from events that would also have harmed CDO investors. But there was literally no one “hoping to benefit from a decrease in the value of the referenced assets” in totality. If you die, a whole bunch of people whom you don’t know and who don’t know you might benefit from buying your crap cheaply at your estate sale. There are even professional estate sale vultures, who make a business of taking the other side of estate liquidations. But it’s quite a jump from dispersed market interest to a claim that there is someone out there hoping to benefit specifically from your death. Dispersed market interest by estate sale junkies is not “material” to how you conduct your life. But if someone in particular really hopes you will die so that they can take your shit, you’d want to look over your shoulder.

I won’t go so far as to say that Goldman is lying, when it claims that “[b]y the very nature of a synthetic CDO”, one party hopes to benefit from an increase and another party hopes to gain from a decrease in the value of the referenced assets. But I will say that that the statement is factually wrong, and that Goldman knows very well it is factually wrong. If we are generous, we might categorize the statement as a sloppy simplification, a rhetorical imprecision that happens to flatter Goldman Sachs.

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[1] If a position is not client-initiated, but initiated by the bank in response to some other party’s wishes, then the bank is not acting as a market maker but as an agent for the initiating party. An investment bank is free to act as an agent for a client when it trades at arms-length in public markets. But it may not act as an agent of a client while transacting with underwriting clients, unless it discloses the nature of the relationship. This failure to disclose is the essence of Goldman’s ethical foul in the ABACUS deal. It is also, I think, why Goldman is fighting the case so hard. Goldman gains competitive advantage by letting underwriting-driven demand take on customer risk that Goldman itself is unwilling to accept. There is, in the lingo, a synergy. But it is also an unethical practice, in violation of Goldman’s duty to its underwriting clients. I think Goldman is fighting so hard because it benefits from this synergy and wants to keep it. Goldman wants to normalize the practice, and rhetorically attempts to do so every time it protests that market makers don’t disclose the identity of counterparties. When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed.

This entry was posted on Tuesday, April 27th, 2010 at 7:09 am PDT.
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