(updated Sunday, April 18 with details on synthetic CDO due to questions from a reader)
Last year, in a statement that made me momentarily question my understanding of the English language while simultaneously wonder whether I had inhaled too many potent diesel fumes over the years, Goldman Sachs' CEO Lloyd Blankfein declared, in a detailed interview, to a reporter from the The Times (London) that he and Goldman were not only part of a "virtuous cycle" that serves a "social purpose, " but, in fact, that together with his holy $1 Trillion firm, he was actually "doing God's work" (pg 4 of article). Yes, you read that correctly.
It was, apparently, through "doing God's work" virtuously and with social purpose that Mr Blankfein and Goldman felt absolutely justified in taking $12.9 Billion from the American taxpayers during the AIG counterparty pay-out festival; through "doing God's work" that the former investment bank was miraculously converted to a bank-holding company by the FR in late 2008 so it could take $10 Billion more in taxpayer dough through TARP; and through "doing God's work" that it issued $1.1 Billion of taxpayer-backed debt through the FDIC program. That's $24,000,000,000 from the taxpayers--wow, "doing God's work" sure does pay, but who'd ever think it had $$$ in front of it!
And, who'd ever think that for Goldman, "doing God's work" includes screwing its own clients to the tune of $1 Billion and committing FRAUD? Indeed, that the market-shakingly big news that hit the fan yesterday (Friday, April 16). The long-speculated but heretofore unconfirmed SEC investigation into Goldman Sachs' sales of toxic CDO's to clients in 2007 has finally culminated in not only confirmation, but action: The SEC has officially alleged Goldman Sachs engaged in FRAUD.
Repeat: the SEC has filed a civil lawsuit against Goldman Sachs on behalf of investors who were, according to the SEC, defrauded of over $1 Billion by Goldman through what was really a complex double-crossing fraud operation. We've known about this for some time, thanks in huge part to the awesome McClatchy News multi-piece expose published last November, "How Goldman Secretly Bet on the US Housing Crash." And, of course, those $1 Billion worth of investors--including pension funds, labor unions, insurance companies, etc--have long suspected that they were defrauded by these banksters. But that's not important--what's important is whether or not the SEC agrees, and on Friday they demonstrated that indeed they do.
Actually, its hard for the SEC not to agree: the evidence is overwhelming. Please read the McClatchy piece from last year and then these current Bloomberg articles (first, second, third) the raw details, because my quick explanation is actually only a matchbook-cover overview. The SEC complaint is 22 pages long (pdf), but I'll try to boil it down a bit.
Basically, it's like this:
1.) GOOD TIMES: It's sometime between 2002 and 2006, and the housing bubble is booming: Goldman and everyone else begins purchasing securitized mortgages bundles--mortgage backed securities, or MBS--from underwriters who can't sell them fast enough. Goldman keeps the "assets" on their balance sheet, because in the good ole' days here in 2002 through 2006, these securities are performing very well and increasing in value. Everything is great, dude. Goldman sells some of the MBS to others at a profit, and keeps some for itself. This is so super--everyone has a house, and house prices can't possibly fall. Uh, oh--what do you mean you can't make your house payment? What do you mean no one will buy that 600sq-ft shack for the $400,000 you paid for it? Oh, great, here we go. Enter the crisis.
2.) CRISIS: By mid-2006, some of the underlying mortgages of the various MBS begin to default, and by 2007, vastly overinflated home prices being to really reverse. A crisis is coming or here: suddenly, Goldman's dandy MBS are not only failing to pay the coupon, but are seriously losing value. Goldman tries Plan A: the firm decides to sell some while it can, but the over-saturated market is full of others doing the exact same thing. Plan A fails. Goldman moves to plan B. Enter ABACUS.
3.) ABACUS: Goldman starts issuing collateralized debt obligations (CDO's) by selecting bundles of MBS (collateral), securitizing them, and then selling them as securities (or debt) to clients (obligations). There are two types of CDO's that Goldman issues: "plain vanilla" CDO's and synthetic CDO's. Its an important distinction: plain vanilla CDO's are created when Goldman takes a portfolio of cash-flow producing assets (like MBS), bundles them up, and slices them into different risk-based tranches that each pay investors a different coupon. The higher the tranche, the lower the risk, and thus the lower the coupon payment. Conversely, the lower the tranche--that is, the more exposed to subprime loans--the riskier the bond, and thus the higher coupon. Goldman sells billions in plain vanilla CDO's, and seeing both the need to hedge itself further as well as the potential to profit from falls in the market as the bubble deflates faster, Goldman starts issuing synthetic CDO's by the name ABACUS. Unlike regular CDO's, synthetic CDO's do not require anyone to own a portfolio of asset-backed securities, but are instead "linked" to the performance of ABS through what is basically a contract bet (more details on this soon). On top of the billions of regular CDO's its already sold, Goldman issues at least $7.8 Billion of these synthetic-CDO's under the name "ABACUS," but according to Bloomberg, the dollar-risk shuffled over to investors is actually "multiples higher" than $7.8 Billion. Like regular CDO's, the synthetic-CDO "investments" entitle the purchaser clients to payments from Goldman, but Goldman itself is able to vastly reduced its own exposure by getting some of the debt off its its balance sheet. Goldman, however, is still in the position to lose money, and so the firm needs to hedge. Enter the other side of ABACUS--CDS.
4.) CDS: Synthetic CDO's aren't based on the cash-flow from some underlying mortgages bundled into a security and divided into tranches like a regular CDO is--instead, they basically consist (and pay-out) of one each side betting against the other on the performance of an "associated" group of debt. Both the cash flow and the betting on the synthetic CDO is accomplished through credit default swaps, or CDS. In a synthetic CDO contract, the seller (Goldman) is effectively shorting the associated assets by purchasing a credit default swap from the buyer (investors, clients), meaning that Goldman has to make regular payments to the buyer of the CDO (who is now the seller of a CDS). This creates the cash flow that makes a synthetic CDO look like a regular CDO, as the investors are recieving payments for the CDS "policy" that are much like the coupon payments they'd be recieving in a regular CDO. However, in the synthetic CDO, if the associated/linked assets go bad, the buyer of the CDO (investors) who is also the seller of the CDS now has to pay the buyer of the CDS (Goldman) who is also the seller of the CDO--and they have to pay the entire face value of the debt, even if Goldman doesn't own it, which in all cases of ABACUS, they didn't. The CDS coverage on the synthetic CDO's therefore make it more profitable for Goldman that the synthetic CDO's its selling to its clients fail than it does for them to succeed. If they fail, the clients are on the hook for debt to pay Goldman. While this is bad, and probably unethical, and insanity that anyone would make this agreement with Goldman, its not actually fraud yet. At least at this point, Goldman itself was selecting the underlying assets from its own portfolio, and so was at least partially co-investing, even though it was still covering itself with the CDS "insurance" and pushing the risk to investors in a fashion "multiples higher" than to itself. Where it starts to move towards fraud is when, for the last ABACUS synthetic CDO set, Goldman turns to some third parties to pick the collateral and create the portfolios, which it then will sells with not only zero liability of its own, but that it takes a bet out on to fail. The fraud part has to do with the third parties and the Goldman executives who know it. Enter Fabrice Tourre.
4.) FABRICE TOURRE: While Goldman had already sold billions in CDO's and ABACUS synthetic CDO's that consisted of portfolios it had itself chosen, in 2007, the firm decides to issue synthetic CDO's selected by a third-party group, ACA Management. The debt, sold as "ABACUS-2007 AC1," is under the principle supervision of Goldman executive Fabrice Tourre. Tourre delivers a portfolio of picks made by the $30-million-dollar hedge fund, Paulson & Co, to ACA to consider for selection, and tells ACA that Paulson & Co plan to invest $200 million in the portfolio. ACA itself will eventually take the majority position on the CDO--fronting some $951 million--and so the group obviously has an interest to select collateral that will not fall in value. Goldman, meanwhile, is marketing the debt to clients, stating ACA's dual role as both majority holder and collateral selector as proof that the CDO will have a rock-solid base, and "leverag(ing) ACA's credibility and franchise" to sell the contracts (SEC complaint, pg 8). When ACA receives the Paulson picks from Goldman exec Tourre along with his assurance that the hedge fund will invest $200 Million, ACA is assuming that Paulson's interest must be in-line with their own, and so ACA accepts the Paulson picks. They assemble the ABACUS-2007 AC1 synthetic CDO, and Goldman starts selling with no exposure. By this time, Goldman is outright shorting the MBS market, and so the firm itself takes out more CDS on the ABACUS-2007 AC1 synthetic CDO's, even though they have no exposure: they aren't hedging by this time, they are betting. ACA, meanwhile, is still believing Tourre's statement to them that Paulson & Co plans to invest that $200 Million. The money never comes.
5.) PAULSON & CO: Not only is Mr Tourre's statement to ACA that Paulson & Co plans to invest $200 million in the portfolio totally untrue, it is actually the outright opposite of what the investment outlook of Paulson actually is. In truth, Paulson & Co has long since identified the housing market as an incredible bubble, and is shorting everywhere it can. Paulson & Co sees the new ABACUS synthetic CDO's, and, knowing it is very likely to fail--at least in part due to the fact that Paulson picked the underlying securities to which it was associated with the intent of those securities failing--the hedge fund piles up on CDS against the ABACUS 2007-AC1. What ACA, and all of the investors to whom Goldman was pitching and selling the ABACUS 2007-AC1, do not know is that Paulson & Co actually paid Goldman $15 Million to get ACA to somehow include the hedge fund's toxic picks into the ABACUS portfolio, and Mr Tourre with his made up stories, got the job done. Now, that, ladies and gentlemen, is fraud.
The rest--the implosion of the CDO and the pay-out of the CDS to Goldman and Paulson are now history, and the story is best summarized in the SEC complaint by this statement (pdf pg 3):
"The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson's opposite CDS positions yielded a profit of approximately $1 billion for Paulson."
"Our clients always come first."
And so, that is were we stand this weekend. The flesh of the SEC suit is that Goldman not only allowed Paulson & Co to hand-pick mortgages to create the most toxic CDO's possible for Goldman to sell, but that Paulson & Co paid Goldman $15 million for the privilege to do this--and Goldman didn't bother to disclose these facts to the clients, nor did it bother to mention it was itself betting against the very CDO's Paulson's picks yielded. Additionally, the investors who bought the synthetic CDO's have claimed to the SEC that Goldman also did not disclose that the values of the underlying mortgages themselves were based "on inflated appraisals and were bought from firms with poor lending practices, " despite the fact that Goldman knew this, as well.
On Goldman Sachs' site is a list of "Business Principles." The top one, in bold, states "Our clients' interests always come first." Obviously, Paulson & Co is very happy--a billion bucks worth of happy--that this core Goldman Sachs "business principle" is, apparently, only half-true.
Perhaps the words of one my favorite analysts, the hard-core researcher Christopher Whalen of Institutional Risk Analytics, summarize it best. Whalen stated yesterday that “this litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another.” Yep, that's why we call 'em banksters, Mr Whalen. You can't trust them as far as you throw them soaking wet--and honestly, I don't have much sympathy for those that do. In my opinion, when you're dealing with a group of folks whose entire livelihood rests on the "legalized" counterfeiting of the American currency, you ought to expect fraud. And the beneficiary of the fraud in this case was both Goldman and its privileged client, Paulson & Co.
The idea that Goldman would accept a list of picks for an MBS-associated synthetic CDO from a hedge fund that was actively and passionately shorting the entire subprime MBS market is bad enough, but to get paid $15 Million by that same hedge fund to "oh, please, please please" use their toxic picks--bloody hell, man, that is just so bad. Top it off with Goldman's own bets against the "investments" that it was selling, and you've got a real whopper there. In his Rolling Stone piece, "The Great American Bubble Machine," Matt Taibbi colorfully declared Goldman Sachs "a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money." With my very visual mind, I laugh every time I read that great description, but like the "Business Principles," its only half true--and you'd know it if your "humanity" was with Paulson & Co. In that case you'd be thinking, "Oh, vampire squid are so cute!"
Paulson & Co.
Please note, the SEC has not charged Paulson & Co with any crimes, and likely will not, because as a private investment group, the hedge fund is under no legal obligation whatsoever to disclose anything, nonetheless to investors purchasing debt from another company. In response to the SEC complaint, Paulson & Co said the following in a released statement:
". . . we were not involved in the marketing of any ABACUS products to any third parties.
"ACA as collateral manager had sole authority over the selection of all collateral in the CDO, securities of which were subsequently rated AAA by both S&P and Moody's."
"Paulson did not sponsor or initiate Goldman's ABACUS program. . ."
Compare that to the following, from the SEC complaint itself (pg 2):
"GS&Co marketing materials for ABACUS 2007-AC1 -- including the term sheet, flip book and offering memorandum for the CDO - all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third-party with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. ("Paulson"), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps ("CDS") with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson's adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials provided to investors."
"In sum, GS&Co arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse economic interests."
Those are strong statements from the SEC that Paulson did "play a significate role in the portfolio selection process" for its own "economic interests," and Goldman, of course, didn't bother to mention that. ACA Management, meanwhile, has long since drowned in the wake of the crisis, and is now under the ownership of its former counterparties. As for Goldman Sachs: the firm will likely declare a $4,000,000,000 first quarter profit when it reports next week.
Hey--its all about "doing God's work," son.
More posts on this to come!
Your 3 and 4 don't sound right. You say that GS got the CDO's off its books but still had to hedge. Hedge what? Any proceeds from a CDS that is a genuine hedge would have to be used to cover the losses being hedged. But what losses were those? It's possible that GS bought CDS contracts on risks it no longer held, but that's not a hedge; it's an insurance contract without an insurable interest - a very bad thing, as anyone who knows anything about insurance knows. But none of these details are in the SEC complaint, so it's not clear what facts come from what sources.
ReplyDeleteAs regards Paulson, GS issued its own CDS to Paulson and then bought one to hedge that risk. Thus, as the SEC said, when the CDO's failed, GS collected on its CDS and sent the money to Paulson. That's how Paulson made his money.
Paulson is the one who bought the CDS on assets he did not own - indeed, defective assets that he sold and then insured even though he no longer owned them - and waited for them to implode. GS knew that was the plan, so they hoodwinked ACA/AMRO into backing GS's CDS to Paulson.
It would all have been so simple if all of the ultimate insurers had made sure that each insured had real skin in the game. But they didn't.
The real question you have to ask is why there was so much money around to fund these bogus deals. Why was there so much demand for US paper that we were able to fill it with manufactured, fraudulent mortgages? Wall Street has always been greedy, and its bankers always well-paid. What changed to make these facts fatal this time? Why was so much capital entering our system through the Port of New York's Wall Street Dock?
Mr Kramer,
ReplyDeleteThank you for your comments! In regards to GS's hedge on the CDO's (your questions on 3 and 4): I should have been more clear in explaining that the ABACUS CDO's are not just any CDO's--they are synthetic CDO's. I tried to keep the explanation as simple as possible, but your comment tells me that I should clarify this.
To answer your question, the reason GS still needed to hedge against the ABACUS CDO's was because the firm was still the one on the hook for the regular payments to the investors in those synthetic CDO's it sold. Whether synthetic or not, CDO's are similar to bonds in that the purchasers receive regular payments from the sellers. It is analogous to the premiums that the purchaser of a put option would pay to the writer/seller of the option, but on a continuing basis. Sellers of CDO's are effectively taking short positions on the underlying debt, while the buyers are long.
Goldman still needed to hedge because, as it was selling synthetic CDO’s, it still owned the underlying debt: the reason GS had to bundle and securitize the debt was because there were no buyers for it. The debt was taken "off balance sheet" in accounting terms through the use of the synthetic CDO (similar to the Citigroup use of regular CDO’s to shuffle debt), and as the linked Bloomberg article notes, the risk was shifted by a fashion "multiples higher" TO investors FROM GS, but GS was still exposed as the holder. Remember, from the buyer's perspective (ACA and the investors), the synthetic CDO is a long bet on the performance of linked debt where the investor is selling (guaranteeing) CDS on the debt in return for regular premium-like payments on the CDS "policy," while from the sellers perspective (GS), its a short on the debt and thus a bundle of CDS that are purchased from the buyer on the hope that they buyer will have to pay up (which for Goldman, would cover its exposure). In the synthetic CDO, neither side needs to actually own the debt, because the contract is “linked” to the performance of the debt no matter where it is. And then, of course, you can have people
(cont)
ReplyDeletelike Paulson & Co who are totally unrelated placing further bets. After GS sold the syn-CDO to ACA (and received its bucket of CDS in return), GS then, as you stated, sold a CDS to Paulson. You also stated that GS paid Paulson with money collected from it own CDS, and this is true, but as the SEC suit points out (example, pg 19) Goldman only got the money on its CDS from the original purchasers of the CDO (ACA Management, RBS, IKB Credit Management, and the others) who were the other side of that CDS bucket. Also, remember that meanwhile GS was collecting fees from Paulson as the guarantor that the Paulson CDS, and GS received the $15 million alleged in the SEC suit to have been paid to GS once the bad apples got into the ABACUS 2007-AC1 pie.
You're right that none of this should have happened, by the way, and that real skin in the game should be required. I didn't comment on it in the post, but I personally think ACA is outright negligent for simply taking Paulson's picks and Tourre's word--that is just lazy in my opinion! I don't have much sympathy for people or institutions who invest in this fairy dust stuff. That said—it is still fraud and it still needs prosecution, and the fraud alleged is very specific: the SEC complaint is targeting only ONE of the nearly two dozen ABACUS synthetic CDO's sold by GS--the ABACUS 2007-AC1. The uniqueness of this ABACUS syn-CDO was GS' use of a third party collateral selector--ACA Management--which was NOT removing debt (RMBS, regular CDO's, etc) from GS balance sheet, but selecting it for linkage from other sources while Goldman Sachs’ role, according to the SEC complaint (pg 1), was that it "secured and marketed" the syn-CDO.
Finally, for you last point--WELL SAID. These ARE "bogus deals" perpetuated by ridiculously easy money and insanely rampant credit. And as you know, it didn't used to be this way. It used to be that you did indeed need "skin in the game," and as such, there was only as much exposure as there was debt. The invention of various special investment vehicles, special purpose vehicles, CDS, CDO, synthetics, and all of that nonsense has given us the $1.5 Quadrillion derivatives market. In my opinion, one of the biggest things "that changed to make these facts fatal this time" has to do with the Basel II minimum capital requirements and the generalized "synthesizing" of money. I have written much about Basel II over the past couple of years, and as I have just started this blog page recently, I haven't had time to post it--but I will. Thank you for you thoughtful comments, and please contribute your leads and opinions any time!
Keri - Thank you for the reply. I hope you will stay with me a while longer, because I think it will clarify things not only for me but for others.
ReplyDeleteI am confused about who's on first. My image (I hesitate to call it an "understanding") of these transactions is that GS issued these CDO's, but that, as you say, they were synthetic CDO's, meaning that no one in our frame of reference necessarily had to own the RMBS paper, the performance of which was just used to measure GS's obligation on the Syn-CDO. Thus, when you say that GS was still exposed as the "holder," I have to ask "holder" of what? Did GS in fact buy the underlying RMBS's as a hedge against their obligation on the CDO? And, if so, wasn't GS's risk limited to the (junior) tranches they couldn't sell, for which GS could buy no CDS, which is why they claim to have lost money on these deals?
I don't understand how GS could both hedge its bet by buying a CDS from ACA AND issue a CDS to Paulson on the same risk. Wouldn't GS need two CDS's for that? You say that GS sold the CDO to ACA, but I thought that GS sold the CDO to IKB, not to ACA. ACA merely picked the bonds (with Paulson's "help") and insured the CDO, for a premium. But, according to the SEC, ACA's insurance (with AMRO's wrapper) covered GS's risk on its CDS to Paulson, not GS's risk as holder of anything. There is no mention of GS getting any net money from anyone for its own account when the RMBS paper went south.
I think the claim that "the risk was shifted by a fashion 'multiples higher'" needs to be explained. What mechanism is alleged for that? Isn't the sale of the CDO a transfer of the risk on the underlying RMBS package that is "multiples higher" than the risk GS retained?
Finally, my answer to the questions at the end of my comment is our massive trade deficit. Basel II, etc., were a response to the presence of the money in foreign coffers. As Robert Frost wrote, home is where, when you have to go there, they have to take you in. Dollars have to come home, and when they do, we have to take them in. Leverage is just another word for bandwidth. We had no choice but to allow it. I think we allowed our currency to be the world's reserve currency when we no longer had the assets or productive capacity to back it up. So we invented some. (See "Triffin's dilemma.")
Thanks again for your reply. Great blog. Call me "Larry."
Hi Larry!
ReplyDeleteFirstly, in regards to GS' sale of the syn-CDO: according to the SEC complaint, the ABACUS 2007-A1 was sold to ACA ($909 Million) and IKB ($150 Million)(pg 18), and others. Besides taking the largest stake, ACA also selected the associated RMBS. The SEC is alleging that GS wanted/needed the involvement and investment of ACA because IKB was "no longer comfortable" with GS' selection of the underlying/associated RMBS that GS was picking for the previous ABACUS deals in which IKB had exposure. I think point (#22) from the SEC complaint explains it very well:
"The identity and experience of those involved in the selection of portfolios was an important investment factor for IKE. In late 2006 IKE informed a GS&Co sales representative and Tourre that it was no longer comfortable investing in the liabilities of that did not utilize a collateral manager, meaning an independent third-party with knowledge of the U.S. housing market and expertise in analyzing RMBS. Tourre and GS&Co
knew that ACA was a collateral manager likely to be acceptable to IKE." (pg 16)
And that is why GS got ACA involved. IKB's contribution was $150 Million on two different tranches of the ABACUS 2007 AC1 (pg 17), a move that IKB apparently only did after seeing ACA's involvement. Of course, unbeknownst to IKB was that ACA accepted the toxic Paulson picks, and I would bet today that IKB is pretty mad as ACA, too (which is now under the conservatorship of its former counterparties). The SEC complaint states that:
"The fact that the portfolio had been selected by an independent third-party with experience and economic interests aligned with CDO investors was important to IKE. IKB would not have invested in the transaction had it known that Paulson played a significant role in the collateral selection process while intending to take a short position in ABACUS 2007ACl. Among other things, knowledge of Paulson's role would have seriously undermined IKE's confidence in the portfolio selection process and led senior IKB personnel to oppose the transaction."
As for GS exposure and hedging: for the regular CDO's it sold (that is, CDO's based on underlying RMBS that GS held), GS still had exposure because the still have the "assets" and were required to make the coupon payments. The syn-CDO's were different, as GS was selecting the associated RMBS and may or may not have actually owned them--we don't know right now, because the first couple dozen or so of ABACUS syn-CDO's are
not under investigation. Only the ABACUS 2007-AC1 syn-CDO is the subject of the complaint, and in that case, GS did NOT own the RMBS. So you're correct that GS did not receive payment from any counterparty went the RMBS upon which the syn-CDO's were based, because GS had no exposure to them in the first place. The hedge was GS's use of the syn-CDO's to cover its remaining obligations on the original billions of the plain vanilla CDO's it had already sold that WERE based on underlying RMBS that GS held.
ReplyDeleteThe reason that these transactions together--the original CDO's and the ensuing syn-CDO's--transferred risk to the investors in a fashion "multiples higher" to the investors is because and is explained in the Bloomberg article from which I quoted, titled "ABACUS let Goldman shuffle mortgage risk like beads." Here's the full context:
"The bank used the deals to off-load the risk of mostly subprime home loans and commercial mortgages to investors, either as hedges for similar positions or to bet against securities itself. While the data show New York-based Goldman Sachs issued at least $7.8 billion of Abacus notes, the risk passed to investors was multiples higher."
The "deals" were both the regular CDOs and the syn-CDOs; the "hedges" were the plain vanilla CDO's that WERE based on underlying GS' owned RMBS, and the "bet(s) against the securities themselves" were the syn-CDO's in which GS was purchasing CDS from the syn-CDO buyers (the ABACUS contracts). Does that make it a little less opaque?
Lastly, I quite agree with you that the massive trade deficit is an integral part of our economic death, and I would add lots of other ingredients (including my very cynical interpretation of the Marshall Plan that HELPED get our trade so imbalanced!). According to my research, Basel II is much more than a response to money in foreign coffers, because it was through the BCBS authorized/mandated use of synthetic capital to meet the new (and ridiculously low) minimum capital requirements that allowed the European banks to use institutions like AIG to effectively provide insurance promises on capital that was NOT reserved, but instead doubly used for additional leveraged lending and purchases (largely of various SIVs!). I like your analogy of dollars with bandwidth--can I use that in the future if I credit you? :) I think of currency as just that--current, and real current (energy) only comes with the corresponding change of real mass (matter). When we introduce this fiat nonsense, we are effectively buying promises to energy that is not backed by mass (something impossible in the real universe)--and, as you state, we now have exponentially more credits to energy (dollars) that we even have mass to generate it from! (To use the e=mc^2 analogy.) And as a result, we have more debt in existence than can ever be "paid back." Your reference to Bretton Woods by your identification of the Triffin dilemma is ON POINT, Larry: like my little e=mc^2 analogy, suddenly there was more energy (dollars) than there was mass (gold) to back it up--and we know how Nixon was forced to remedy that in 1971! We are living in total fantasy land, aren't we?
I greatly appreciate you commentary! Thank you so much!
Yes, I did finally grok that ACA was a "buyer," i.e., that it actually did a swap, taking the CDO as (partial) payment for the CDS. But that did not have to be the case. ACA could have simply sold the CDS and let GS sell the CDO to someone else. Is that not so? (I really don't know, so correct me if I'm wrong.)
ReplyDeleteThe Bloomberg article, I'm sorry to say, is Greek to me. I understand the Paulson deal in the law suit, at least as it is alleged to have worked, but the other Abacus deals, with their "super-senior" tranches, escrow arrangements, etc., are beyond my ken. I'm afraid the reporter did not dumb it down enough for me. But those other deals don't interest me enough to learn them. So, if the "multiples higher" thing is not about the Paulson deal, I'll let it go.
On Basel II, I think you have to ask why the capital levels were set where they were. Synthetic capital, derivative instruments, and high leverage are all capacity-expanders. My sense is that, but for the demand for dollar-denominated investments, none of these would have seen the light of day. And the deficit drives all that. As for why we have a deficit, the Marshall plan (if you like, I'm ignorant on that one), Bretton Woods, oil, and globalized access to cheap labor all figure in. Another of those all-too-common perfect storms.
Feel free to analogize the capacity of the American financial system to move money on shore as "bandwidth." That would make the instruments themselves "media." It's not enough to be able to move a lot of money, you have to have a package to put it in, e.g., a derivative bet on real securities when the real securities just aren't available.
Derivative solve the problem of there being too few things to invest in. You let the investors invest and you open a casino for others to bet on how the investors do. Bandwidth, and media.
I'm not as hawkish as you on fiat currency. I think it's foolish to limit economic activity to what can be financed by existing assets, including arbitrarily distributed minerals in the ground. Should Ghana really have more capital that England because it has more gold? Fiat currency runs the risk of hyperinflation, but life is risk. Agreeing to be poor so that we wont' have to some day give up being rich doesn't compute for me.
Hi Larry,
ReplyDeleteTo quickly address your first question: No, ACA could not have just sold the CDS to GS and had GS sell the CDO to someone else, because the ABACUS deals were synthetic-CDO's. In syn-CDO's, there is nothing to move around--its just dual bet--an option, if you will. The seller (GS) of the syn-CDO is the buyer of the CDS, and the seller of the CDS (ACA) is the buyer of the syn-CDO. Think of it in terms of an options contract, because that's probably the best example to which to compare it.
As for my hawkishness on fiat currency--thanks for noticing. :) You might be slightly misunderstanding the idea of "hard" currencies if you think that its about what minerals are IN THE GROUND in various places, hence your aversion to the idea. The truth is that its NOT about what's in the ground (potential)--its about what has been taken out (capital) through EFFORT (risk). This is simple economics: potential becomes capital through the effort. Minerals are just one example that has been useful for humans over time, but trade is based on the transfer of effort-extracted, capitalized potential from one party to another, whether its a fancy sea shell, a loaf of bread, or a silver coin. Fiat money is made of nothing, and as such NEVER creates wealth--it can only create disparity and inequality, and DESTROY wealth. That it does well, indeed.
If IKB could buy $150m of this CDO for cash, i.e., and not in exchange for a CDS, then why could it not have bought $250m, $500m, or all $1B if it had chosen to do so? GS may not have wanted to sell IKB more of the Sy-CDO, but I don't see why it couldn't have done so.
ReplyDeleteIt's not clear to me that IKB was anything more than a target of opportunity here. If there were no IKB, couldn't Paulson, ACA, and GS have done among themselves the same deal that they actually did among themselves? Certainly, the $150m was not a magic number, which means that GS could have sold as much to IKB as IKB wanted and still bought a CDS from ACA (for a premium) to back the CDS it issued to Paulson.
As you suggested, the CDS is just a naked put. But if that's so, saying that ACA "bought" the CDO only confuses the issue. ACA did have to take the risk on the CDO, which is tantamount to "buying it," but that's a different matter. Every naked put writer in effect "buys" the underlying asset, at least as regards the risk of loss.
On hard money, I agree that potential becomes capital through effort. I just have a broader definition of "potential." I believe that Bill Gates and Paul Allen turned potential into capital through effort, and that there is no reason the world should not regard Microsoft stock as adequate backing for our money. I get that stock fluctuates in value, but that's a different issue from what constitutes potential, effort, and capital. Gold, too, fluctuates in value, and its value, however respected over history, is entirely arbitrary, whereas the value of an idea brought to fruition can be measured in earnings per share and retained earnings.
Moreover, if money has to start as resources in the ground, prosperity in place A may depend entirely on stealing reserve resources from place B. Trading is nice, but only if it is more cost-effective than invasion. It would really be bizarre if the US economy could not grow because countries with gold in the ground refused to sell it to us.
Fiat money, then, helps to keep the peace. If the holder of currency can buy something with the money that the holder values, be it gold, oil, real estate, flatscreen TVs or software upgrades, the money is adequately "backed." The problems arise when there is more currency outstanding than there are things available to buy with it. Granted, that cannot happen with gold-backed money. But that's just the upside of hard money. The downside is an intolerable cost of capital.
But, yes, fiat money can overwhelm its backing, and that's the sub-prime mess in a nutshell. We ran out of things the dollar could buy. Cheap labor killed our manufacturing for export, and all of the people who could afford houses owned them. So we pretended that some people who could not afford houses could afford them, which created an artificial demand that enabled us to pretend that the houses themselves were worth more than they were worth.
Fiat money was certainly a necessary condition for the mess, but life is a necessary condition for death, so that hardly ends the discussion.
Let me know if I'm overstaying my welcome...
Hi Larry,
ReplyDeleteDon't worry--you're not overstaying your welcome by any means. However, I think I will put up a specific post on the topic of fiat money, because our discussion on fiat money (which I am enjoying) is moving away from the original topic of this post. I'll post something along those lines soon, because its an important thread that runs through all of the current financial issues.
As for the syn-CDO's: I tend to agree with you that IKB was sort of a "target of opportunity," which is why GS got ACA involved in the first place. There are damning internal-GS email excerpts in the SEC complaint that indicate that GS needed ACA onboard to get IKB in, so it is clear that GS needed ACA to get IKB, but I agree with you that, given what we know right now, IKB itself was not a necessary piece of the pie. GS and IKB have a long relationship, including IKB's purchase of regular CDO's and even some earlier ABACUS syn-CDO's. IKB is apparently pleased with the SEC action and is contemplating a civil suit of their own, which will probably surface after the SEC claim is settled. Also, please understand that GS did not buy CDS from ACA to counter the IKB investment--they bought it from IKB. That was the cash flow for IKB that got them involved (the CDS premiums) after GS told them that ACA was going in on ABACUS 2007-AC1, too. There were many different tranches with several investors, including IKB and ACA as the biggest, but each investor was the counterparty to the CDS GS bought. So GS was the counterparty to whom IKB paid out the claim on the ABACUS syn-CDO when it went sour, not ACA. ACA covered their own CDS obligations to Goldman seperately (the huge $951 Million obligation). In my opinion, IKB, as a German public bank, should have never been buying syn-CDO's in the first place. But hey, we (taxpayers) bankrolled the Fed's huge purchase of a bunch of that nonsense that is still sitting in Maiden Lane II and III, so the Germans aren't alone!
As for my terminology: I should probably say "position" instead of "bought" or "sold" in regards to syn-CDO's and other derivatives, because they are so similar to options, and I understand that this stuff is all very confusing and unintuitive, so I don't want to obscure it further. I think from now on I'll use the term "position," as in "ACA took a (long) position on the syn-CDO." Thank you for pointing that out.
Be sure to check back later for a post on fiat money, and comment on whatever else you'd like to in the archives or front page. I'll be looking for you. Its been a pleasure, Larry!
Great Job Keri, I love to hear your comments on the Rolleye James show you are so intriguing I find your research and comments very valuable. Ilove your blog and will follow you and your research with much interest. Thank You and keep up the great work. Roll on !!!!
ReplyDeleteI'm afraid we're too deep in the weeds on the IKB structure, and I'm more interested in the legal fallout. IKB was effectively long a reference portfolio that it allegedly went to great lengths to assure itself was not picked by a short and yet was at least tainted by the participation of one. IKB will probably sue GS, ACA, Paulson, and Moody's. Its cases against ACA and Moody's are essentially product liability cases, as IKB had no formal arrangement (privity of contract) with either of those firms. That works for suing car companies; I don't know if those fly in finance.
ReplyDeleteEach ACA entity has its own case against GS and Paulson. (We'll leave Moody's aside for now - they should just be consigned to the Ninth circle of Hell and the heat turned up.) ACA Management was duped into conferring with Paulson. Anything it owes IKB (or other investors) on account of its portfolio selection process being tainted, it can try to recoup from GS and Paulson as co-conspirators.
ACA Holdings was allegedly misled by GS and Paulson about the possibility of adverse selection in its CDS underwriting process. If the CDS were treated as the insurance contract like which it existentially quacks, the withholding of Paulson's interest would be grounds for voiding the contract. I guess ABN/AMRO has inherited the right to complain about that one.
Obviously, last Friday was a very good day for at least some lawyers.
I invite you to look at some of the posts in my blog for further commentary, starting with my very first posts last Spring.
Hi Larry,
ReplyDeleteI agree that there a few dozen lawyers' whose days were made last Friday! Securities fraud is big bucks for counsel.
One thing about IKB: you said that you have heard/read that IKB allegedly went to "great lengths to assure itself was not picked by a short." I have not heard this claim, and honestly, I don't think it is actutally possible, because the very nature of the syn-CDO's (all the ABACUS deals) included the counterparty's short position--and IKB knew this. The actual structure of the syn-CDO's consists of a long and a short, and as IKB knew they were taking the long position, they also knew someone was taking a short position--the cash flow was the premiums from the shorter (just like in an equity short). The fraud part is that GS did not disclose to IKB that Paulson had picked the collateral in the ACA portfolio to which the syn-CDO was linked. But IKB definetly knew there was a short side. I know you are just reporting what you heard as alleged, so I just wanted to clear that up.
As far as cases against Paulson: I wouldn't be surprised if someone sued him, as $32 Billion is a deep set of pockets. But Paulson had no legal requirement to disclose anything, so I can't see how any case against them would even have grounds to proceed. Paulson is not responsible for explainting to GS clients the terms of GS contracts--that's GS' duty. Any counterparty in these syn-CDO's (or any other derivatives) is de-facto a member of the "sophisticated investor class," as these products are not even available to Joe Sixpack. Also, remember that in 2007, Paulson was considered a raving nut on Wall Street, and both ACA and IKB specialized (supposedly) in researching these very contracts and the collateral. I cannot see how Paulson would have any legal liability whatsoever in regards to this, and the hedge fund has not been charged with anything, civil or criminal.
Thanks for your comments, and I will check out your blog also!
Hey COORS:
ReplyDeleteRight on, thank you! I'm glad you're here, and I'll try to keep new things posted as I can. Rollye is very kind to link me up, and, as you konw, the show is a great source of information and discussion for us all. Check out the archives to see lots of posts regarding issues and topics that Rollye has covered in the past. Thanks for checking the blog out!
Keri -
ReplyDeleteThere is a difference between knowing that there is someone on the short side of a transaction and knowing that the short picked the actual mortgages (or influenced the selection) in the expectation that they would fail. IKB feared that GS might be such a short, so IKB insisted on an "independent" selector, ACA, to assure that the best possible portfolio was selected. It's all in the SEC Complaint.
I addressed this issue in a blog post last night. I edited it a few minutes ago, so if you read it earlier, you should take a look at the "For every long there's a short" section again.
The "big boys don't cry" argument is addressed there as well.
Hi Larry,
ReplyDeleteIn case you're thinking that I'm excusing what GS did any way, please be assured that I am not. Nowhere in anything I've written is there any defense whatsoever for GS engaging in what I believe (in concurrence with the SEC) is fraud. I will say that in my opinoin IKB should have never been purchasing syn-CDO's from any dealer, but my opinion is completely besides the point, because it does not excuse GS from committing fraud. I have never made the argument that "big boys don't cry": I have only said that I'm not crying for them--not IKB nor ACA (nor even ACA's creditors who now own the operation). I'm utterly unconcerned with cyring: I care about the law, and when the law is broken and fraud committed, and I don't care who's crying or not, I want action.
My opinion of IKB is simply that it was outright irresponsible in purchasing syn-CDO's in the first place. IKB is a high-level commericial bank which has access to whatever information or professionals it wants, but what it wanted most in 2007 was a higher yield, and so they took some risks. In the ABACUS deals, IKB could have certainly demanded to see the ACA portfolio as a condition of investment and examined it independently: they certainly had the resources, money, and manpower. There is nothing in the the law that prohibits them from doing that, and if Paulson could figure out what was likely to fail, so could have they. IKB did not, however, conduct those examinations because they trusted ACA, and ACA trusted GS--criminal GS, who was LYING about the source of the portfolio picks as far as intention (they did tell ACA it was from Paulson, upon which ACA did not follow up). In my opinion, GS gave ACA a bag with a bomb in it and told ACA that it was birthday cake. ACA took the bag with the bomb over to IKB's house to celebrate, and told IKB also that it was a birthday cake. The bag blew up, and IKB and ACA figured out it wasn't a birthday cake afterall. Of course, GS knew all along, and had taken out an insurance policy on the house. GS is the one who committed the crime and must be punished. I'm just saying that it is a matter of fact (that is stipulated in the SEC complaint) that if either ACA or IKB independently would have been more investigative and researched the associated CDO's linked to the syn-CDO (ie: opened up the bag), they would have never been taking the positions they did. But that still doesn't excuse GS.
ACA and IKB can and will and should use whatever civil legal avenues are available to them to possibly recover losses based on this fraud, and I would support that action against GS. I would also tell IKB, however, that in the future it ought to use the resources it has and not be so careless.
Thanks for your thoughtful comments, and your blog!
Keri -
ReplyDeleteI have to disagree on IKB. IKB could have done all the things you say, but why should it have to? That's what the people it trusted get paid to do.
It's not irresponsible to wear only a belt and suspenders just because you could have worn overalls instead of pants. To say that IKB should have expended resources to prevent getting played on this investment is to say that it should do that on every investment, in which case it might as well have started its own US-based investment bank. I don't believe the inefficiencies of such an approach are justifiable. The USA cannot afford to be so risky a place to put money if we hope to import so much more than we export or to issue the world's reserve currency. Those things require that investing here be easy. It's part of the deal we have with the world: take our dollars; AAA-rated US paper is A-OK.
IKB was playing the Basel II game of buying AAA securities so that it could be more leveraged. (See my latest blog post.) The investment probably did not appear risky, and ACA protected itself prudently, in my view, by using trusted providers.
Having gone a bit deeper into the weeds, I now believe that IKB's participation in the deal was essential to GS. IKB's position made possible the super-senior tranche that made synthetic CDO's so profitable.
ReplyDelete