Random derivatives musings and the Goldman complaint…

Chris has an interesting post on financial derivatives.  Rather than write a lengthy response in the comments, I’ll elaborate here.  I could use a little more output anyway. 🙂  Also, if anyone has not read Francis’ response in the comments section in Br. Chris’ post, please do so now as I will cite it.

– I don’t agree with Graham Summer.  I think he overstates the role that derivatives played in the crisis and I think when he uses a number like $1,000,000,000,000,000, it fails to take into consideration, as Francis noted, the offsetting positions that are common especially amongst interest rate derivatives.  The notional value of the interest rate swaps is very high (trillions); however, since they exist on both sides of the trade, they essentially cancel each other out.   Also, as Francis noted, the majority of interest rate derivatives are of no threat to the financial system.  This is not to say that a company can get burned by entering into these agreements but the consequences aren’t systemic in nature.

– I think Francis’ simplistic (not in a bad way) version of events puts the role credit default swaps played in the crisis in the proper light.  They were not only being bought by investors who were holding the underlying securities but also bought by speculators in pretty sizable quantities.  While he identifies the problem with having a net seller of CDS contracts woefully undercapitalized, the other problem was the perceived counterparty risk associated with having a major player like AIG collapse (see the first graphic in this Rortybomb post).  The counterparties were very intertwined in a very opaque way.  If I had a short CDS position requiring me to pay Jaybird in the event of a XYZ Company default and I had hedged that with a long CDS position that would have paid me the same amount under the same circumstances, my net position is zero.  Whatever cash I receive from the payout goes to Jaybird.

If AIG was my counterparty and my counterparty failed to make good, I’m up a creek in a huge way because I would still owe Jaybird and have to make good on my obligation.  I would have to come up with the case, and if I am operating a highly leveraged fund, I’d have to sell assets to cover that obligation.  It’s a very bad situation, and a lot people were worried about this because had AIG been allowed to fail, the number of counteparties involved was high and AIG’s failure could have brought a lot of them down.  Making matters worse was an opaque market where there was great uncertainty as to the amount of counterparty risk that existed. 

To the Goldman stuff…

I’ll break down what has been alleged via the SEC’s complaint and explain it in my own way:

1. Goldman (“GS”) was approached by a client, John Paulson, to structure a collateralized debt obligation (“CDO”) that he could take a short position.  For this, GS was paid a fee of $15 million by Paulson.  At the time, Paulson was very bearish on the subprime mortgage market and amassed significant short positions (i.e. betting that the market is going to go down) through his hedge funds.  Paulson ended up making billions of dollars on these positions.

2. Paulson had enormous influence  selected which assets were going to be included in the CDO.  Those he did not specifically select he held veto power over.  Not only did he select substantial portions of the portfolio but his economic interests were ultimately aligned against the portfolio as he took short positions against the same portfolio by purchasing credit default swaps on certain tranches of the CDOs.

3. When GS was structuring the transaction, it misled the third party management company (an investment manager for the CDO), ACA Management, LLC (“ACA”), a reputable third party investment management company by telling ACA that Paulson had a $200 million investment in the equity of the CDO.  ACA understood that to mean that Paulson’s selection of the portfolio was economically aligned with his interests.  What GS knew and ACA did not was Paulson’s intent to bet against the CDO.  The $200 million equity position was apparently an illusion given that Paulson was net short the CDO and ultimately made $1 billion when the CDO crashed and burned.

4. The GS  marketing materials disclose to investors that the portfolio was selected by ACA and fails to make mention of Paulson’s involvement in the portfolio selection or his economic interests in the transaction.  Potential investors believed that ACA was the portfolio selection manager and that it’s portfolio selection represented an alignment of interests with potential investors (especially those looking at the investment grade tranches) looking to achieve moderate yields on their invested capital.   GS is alleged to have withheld this information from potential investors.

On its face, how this is going to be taken is that GS (and other investment banks – see Magnetar) were double dealing with utter contempt for the buy side.  On one hand, they were creating portfolios that were designed not for the long-term economic interests of the investors, but for hedge fund clients looking to bet against the subprime mortgage market.  To allow their hedge fund clients to do this, they had to sell the securities in the market and they did so omitting material facts to both the investors when they were selling the deal and to ACA when the portfolio was being structured largely by Paulson.  It’s not unreasonable to suggest that this conflict could have scared investors away or forced ACA to back out of the deal rather than risk its reputation by endorsing a blatant conflict of interest. 

Unlike Br. Chris, I think this is a pretty big deal.  The allegations are serious and could be much farther reaching within the firm than a VP-level trader (assuming the facts are true, I don’t the SEC will settle for a mid-level employee especially since these deals are vetted in committees with senior level employees (although not necessarily C-Suite[/efn_note].  Also, between the Goldman allegations and the Magnetar story, it makes me wonder how many more transactions like this were done and by who.  Also, how this plays out with respect to financial reform remains to be seen.  There are still a lot of unanswered questions, but this story can go places and it’s worth keeping an eye on it.