Addressing Goldman’s defenders…

Writing at RealClearMarkets, John Tamny attempts to defend Goldman Sachs against the SEC’s allegations.  His defense, aside from the SEC bashing (some of it deserved), seems to hinge on a simplistic Trading 101 description of how the world works.  I’m not convinced:

Investment products at any Wall Street firm frequently materialize due to demand from its sophisticated client base looking for ways to play a variety of markets. Goldman’s clients are nothing if not sophisticated, and while the full details of the buyers of ABACUS haven’t yet emerged, it’s fair to say these weren’t buyers of the retail variety.

As for the Post’s clear-eyed suggestion in hindsight that the securities “would probably go bad”, this wouldn’t have been relevant to the investors who piled into the fund, particularly in 2007. Indeed, as author Michael Lewis has made plain in his new book, The Big Short, by the end of 2006 there were 13,675 hedge funds reporting results, and the bearish view of mortgage securities had “in one form or another, reached many of them.”

Lewis’s point was that while well known and analyzed, the bearish mortgage vision in ‘07 was the minority one. Back then, the broad market consensus was that mortgage securities were set to rise as evidenced by how easy it was for what Lewis termed the “more than ten, fewer than twenty” investors and funds that made “straightforward” bets against the subprime mortgage market to do so very inexpensively. In Tourre’s case, no matter his bearish views, investors didn’t agree, and Goldman was simply responding to client demand for exposure to the securities that Tourre was allegedly skeptical about.

Deutsche Bank’s Greg Lippmann plays a prominent role in Lewis’s book, and while he developed a bearish view himself, this didn’t keep him from servicing clients on both sides of the mortgage trade. This is important too, because numerous commentators are presently trying to suggest Goldman ignored its internal code of serving clients first on the way to marketing ABACUS. The mere suggestion is yet another example of how foolish the commentary surrounding this non-scandal is.

Implicit in the anti-client argument is that the customers served by Goldman back in 2007 were monolithic in their views about the future direction of mortgages. It doesn’t take a genius to realize that the very presumption is and was absurd, and so from an outsider’s point of view, it’s very apparent that when it came to the fund in question, Goldman served the needs of a variety clients with a variety of views. To put it very simply, there are two sides to every trade, so for Goldman Sachs or any Wall Street firm to properly serve its bullish clients, it must find bearish clients eager and willing to take the other side of the trade.

Yes, I do think we need to keep in perspective that the market held a predominatly bullish view towards subprime mortgages in early 2007 and the number of people betting against it were very few; however, I don’t believe the commentary surrounding this situation to be foolish at all.  I am 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 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.

Of course trades amongst two parties to have opposite views.  If I write a call option on Google stock at a given strike price, I am operating under the expectation that Google’s share price will not rise to the strike at the expiration of the contract.  Likewise, the buyer of that contract believes that the price will reach or exceed the strike price.  This is a simple disagreement and each side of the trade understands the disagreement and the substance of the bet (if the share price exceeds the strike price, the buyer purchases the shares at the strike price as opposed to the then-current market price).

As opposed to how I understand John’s argument, I, like Steve Waldman, view the CDOs as securities as opposed to derivatives.  With securities transactions, one does not have to have a “disagreement” with the other side of the transaction.  Investors buying commercial mortgage backed securities from the Wall Street banks selling them were not  bearish on commercial real estate mortgages and the investors bullish so the distinction does not apply here.  More from Steve Waldman (again, my emphasis added):

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…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.

What Steve is saying, and I agree with him, is that the motivation of investors buying the top-rated tranches of CDOs was not speculative in nature.  They were not taking derivatives positions and making bets on the direction of the housing markets.  They were simply seeking yield and looking for an adequate return on a risk-adjusted basis.  As such, they would not see themselves as taking the opposition position as the seller because they were operating under the premise that the seller structured the securities to align with their interests.  John’s explanation would be applicable had the nature of who was responsible for the portfolio selection, John Paulson, been known to them and made the decision to buy the securities at that point.  However, this didn’t happen.

A few other quick fisks:

That being the case, if it’s true that Goldman wasn’t up front with clients about the individuals picking the mortgages that would make up ABACUS, and specifically if it wasn’t up front about Paulson’s role, it’s only mistake was a marketing one whereby it failed to highlight Paulson as the man who would arrange the fund’s holdings. Back then Paulson was not taken seriously, and if his role had been known, it’s a fair bet that client demand for ABACUS would have been even greater.

On what grounds?  Were investors routinely trying to deliberately take long positions on any paper that Paulson was shorting?  What about Paulson’s involvement in the deal would have increased demand from buy-side investors?  This makes no sense to me. 

The other question is that had the CDO manager, ACA, known about Paulson’s intent to short the same portfolio he structured, would ACA have kept its name on the transaction or backed out of the deal?  Would the lack of a reputable third party CDO manager structuring the portfolio jeapordize the deal from coming to fruition?  I don’t know if I would call the exclusion of material information that could have jeapordized the entire deal “a marketing error”. 

So while it’s certainly possible that more distasteful information is yet to be revealed, at this point the story is that there’s no story. What we think we know now is that Goldman’s Fabrice Tourre arranged a fund a with the alleged help of mortgage bear John Paulson, a fund that they may have been bearish about, but that other Goldman clients thought had good prospects.  Goldman clients of varying views were served well here, and that the fund didn’t perform well is merely a reminder that not all investments go up.

John believes Goldman’s clients were well served and believes that withholding material information that I believe could have jeapordized the transaction amounts to a “marketing error” and, it appears, that had the information been disclosed, it would have been no big deal.  This highlights the difference between John and me and Goldman and the buyers of the ABACUS CDO.  I understand the nature and the substance of my disagreement with John.  We agree to disagree.  No harm in that.