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.
I’m in two minds about this. On the one hand it does seem shady, especially if Goldman misrepresented the position to ACA or to investors.
But it is Goldman’s job as an investment bank to enable its customers to take the positions they want to take, and that inevitably means they have to deal with people who want long and short positions on the same deal, and they always have the option of picking one of those positions for themselves. They can choose to be neutral but nothing I know of obliges them to be.
It was genuinely difficult to short the sub-prime mortgage market. Paulson was on of the people who saw problems – there were others – and their main difficulty was in coming up with a short strategy that wouldn’t be incredibly expensive to maintain until the actual crash came. I don’t see anything wrong with Goldman helping Paulson to build and instrument to do it with – he was their customer after all – and nothing obliges them to reveal their position. The only question is, did they mislead ACA or mislead investors? If they did that, I think they may be in trouble.Report
@Simon K, The thing is, the pure question of whether structuring these things so that they could be shorted and also selling them to clients –that’s all totally above-board; no one’s questioning it (legally). It’s just a question of disclosure of who did the picking that they’re on the hook for (maybe).Report
@Michael Drew, Yeah, Dave’s article above this nailed it.Report
There’s a lot to be said about the meat of the posting but one thing is very clear to me; Dave doesn’t post nearly enough submissions on the League. This is really well written and thought out.
I’m gonna mull a bit before I get to the heavy substance though.Report
@North, word.Report
The subjects I am comfortable blogging on are few and most of the conversations at the League fall outside of that scope.
I consider myself somewhat of an outlier since my background is more business and finance. Conlaw is a hobby so I can make myself sound somewhat intelligent on that when I need to.Report
I am fairly certain the timing of the SEC action is to aid the Obama admin’s push to neuter the US financial system.Report
@Scott,
How is the Obama Administration planning on neutering the financial system?
I think that’d make a great topic for a Guest Post. I’ll even respond to it. 🙂Report
@Dave,
The Obama admin wants to regulate the financial industry as much as they possibly can. So they create this GS crisis, which they will use as the perfect example as to why all the new regulation is vital to this country.Report
@Scott, You do realize how this theory comes across to those who don’t share your worldview, right?Report
@Scott,
I think this is the Rahm Emmanuel model of financial reform? Create a crisis so it doesn’t go to waste. Am I missing something?Report
@Dave, And your evidence for this is………..
Was the wee financial crisis the planet had just discovered???Report
@greginak,
I think we’re talking past each other. I was being a bit facetious.Report
@Dave, oh, ur ummmm…ur well i was just being snarky or something….eh.. sorryReport
@greginak,
That’s ok. I was just a bit clueless is all.Report
@Scott, dude, I sympathize but you assume a level of planning and competence that normal folks only fantasize about.Report
@Jaybird,
Really, how hard is it for the Obama admin to have the SEC go after GS? Not very and it gives Obama a talking point about the necessity of his “reform” never mind the actual validity of the suit. When the suit serves its purpose it can be quietly settled with a final win for the admin. I guess it must be coincidence that the GS investigation was announced just as the finance bill debate is heating up.Report
@Scott, allow me to quote you something here:
“So they create this GS crisis”Report
@Jaybird,
Yes, if the gov’t decided to charge Goldman with something they can’t prove just for political purposes they did create the crisis.Report
@Scott,
The SEC has been investigating the ABACUS transaction for some time. The timing may be suspect but they have obviously spent time compiling evidence to charge GS with wrongdoing. They have. There is no crisis here.
Going after Goldman Sachs based solely on political motivation would be akin to career suicide given its prominence and its connection. If the SEC is really THAT stupid, then heaven help us all. I can’t help but give it the benefit of the doubt. Maybe they have their facts wrong but I don’t see that as political motivation as much as botching a potential securities fraud case.Report
@Dave,
I’m sure the Obama admin would like to have both the fraud prosecution and the propaganda victory for their financial regulation bill but if they had to choose one, which one do you think it would be? Oh, and the heads of the agencies are political hacks who will do whatever it takes to keep themselves employed.It sounds like the suit is having the desired effect.
http://www.msnbc.msn.com/id/36642627/ns/business-us_business/Report
@Scott, The neutering I don’t know about, but I would certainly admit the timing is at least fishy. I don’t think that’s enough to make anything ‘certain,’ but yeah, it’s fishy.Report
Stumbled across your site witjh the magnetar trade. Let me clarify. Synthetic CDO came out of the insurance quants in 2002. I’ve been looking and really have not found anyone in the media that has these right. The short CDS positions that Paulson and Magnetar took are the collateral that make up the CDO they sponsored. In order to do this deal they both went long the 5% equity or first loss piece,which had to be placed to close the deal. The equity piece would have a coupn of somewhere around 10%. This helped them finance the CDS premium on the shorts. It is normal for the equity holder to run the deal. You have to remember that when these deals were done these were speculative and anything but a “lock”. The problem here is that the investors in the AAA pieces did not understand the deal structure, much less the fact that they were long CDS. I’m not sure it really matters who is on the other side of the short. If they had not allowed Paulson and Magnetar to structure the deals, they simply would have filled them with CDS from the trading desk, which would have been basically the same paper since the only thing that anyone wanted to buy protection on were the most risky pieces. I don’t really see how the end result is any different.Report
@CM,
I appreciate your insights into a market I only have a cursory understanding of. It provoked a few thoughts of my own:
The structure makes some sense to me and it is intuitive that the equity holder as the investor holding the riskiest long position would want to participate in the deal given its interest in maximizing its return. However, the Paulson/Magnetar situation seems to throw a monkey wrench into this because the way they intended on making money was betting against their own equity positions. Fair enough and I can’t see institutional investors taking issue with that, but would institutional investors take issue with an equity sponsor which is actually net short? Why would institutional investors who were buying the AAA-rated pieces accept this sponsorship issue when there were assumably other deals in the market that these institutions could have participated in?
My experience with institutional investors is only on the commerical real estate side of the capital markets, and from that perspective, I see the institutions as being very “check the box” type investors in the sense that they have their investment parameters and they are the equivalent of an impenetrable wall. Most deviations preclude institutional investors from pursuing deals (at least in my business). Maybe structured finance is different.
If the issue is that the investors in the AAA-rated pieces were clueless (which does seem to the case), then how much did Goldman’s failure to disclose information contribute to the losses the investors incurred since it was the asset class that was ultimately toxic as opposed to the issuance. Had the investors not bought this paper, they’d have bought other junk that led to the same thing.
I think that’s the point your also making.
Do you see the disclosure issue as a problem?Report
Oh, and the heads of the agencies are political hacks who will do whatever it takes to keep themselves employed.It sounds like the suit is having the desired effect.
Regarding the suit having the desired effect, I suppose that’s a bit of a shame since I think the Administration should have the balls to push harder outside of this. Better this come out now than after a weak reform package is passed, but I admit bias since I think financial reform is a necessity.
As far as the policial hacks are concerned, I’m of the belief that if there is (was) a regulatory body captured by the interests it’s supposed to watch over, it was the SEC. Senior level members tend to find cushy employment on Wall Street after their “public service”.Report
Yes, the disclosure issue is the issue. It really depends what was in the docs on the specific deal. I doubt that Paulson was named, but the transaction was probably described with enough legalese that a good portion of the investors did not read all the docs and went on the AAA ratings, which in some cases in the public market is the only box these guys would check. I can remember being taken to the woodshed by management in 2003 for advising clients NOT to touch these deals.Report
I hope Dave is right and I’m wrong on the SEC filing against GS. For an argument as to the kind of thing I had in mind as to why it might not matter all that much here via John RobbReport
This could make things interesting.
http://www.cnbc.com/id/36685026Report
@Scott,
I expect to see a lot of things coming out of both camps that could make this quite interesting. I expect that this will go on for a while.
Of course, if it has this testimony, it begs the question why the SEC decided to pursue charges anyway. We can think about these things until we’re blue in the face, but the facts will play themselves out one way or the other.Report
More news.
http://www.mcclatchydc.com/2010/04/21/92637/goldmans-connections-to-white.htmlReport