WYNN Q1 2010 Conference Call Tidbits

I find Steve Wynn's quarterly conference calls to be among some of the most honest, straightforward and illuminating data points freely available in the market.  Wynn is the best of the best at what he does, and he's even better at clearly expressing himself.  Without further ado, let's take a stroll through the transcript of the most recent call and see what sorts of interesting tidbits we find:  (note: I have no positions in WYNN)

Steve Wynn didn't bother with an opening statement or a review of the quarterly results, simply explaining:

"The numbers I think speak for themselves. Really very little to add to that, except that the first quarter numbers that we released today do not include any contribution from Wynn Encore in Macau, and which opened a week ago today, and we are looking forward to it contributing to the overall impact of our operation in Macau. 

I’m also pleased to announce that we have instituted, announced previously, we have instituted our first quarter dividend of $0.25 a quarter, which will be payable to stockholders of record on May 12th and paid down on May 26th.

With that, I’ll take questions."

Q: From Cameron McNight @ Buckingham: "And then secondly, Steve, you’ve got a lot of cash. You’ve extended out a lot of your maturities. What are you thinking about capital allocation here?"

A: From Steve Wynn: "We don’t think that economic disruption is behind us. We think the deficits have potential for enormous negative impact in the United States. So we are playing it safe like we always do in this company."

I found this to be very interesting, especially in light of the 25c dividend that WYNN declared.  Wynn's strength is that he's kept his balance sheet in check and not levered himself to the point where he risks bankruptcy.  In the past several quarters, he's expressed a very cautious view, which he does again in the answer above - so why is he paying a dividend?!?!??!  

Q: Tom Marisco, Marisco Cap Mgmt: "I was just wondering how you thought about the very high growth rates that you’re seeing in Macau? Why you’re seeing growth rates as high as they are, the sustainability of those growth rates and just more of your philosophy as how you’re seeing that market play out?"

A: Steve Wynn:

"Well, it’s great to have a question from a real live major shareholder like Marsico Capital. It’s not very often that the buy-side guys speak up on these conference calls. Tom, the inherent strength of the market in China has been the subject of great discussion and it has been explained and I know that you’re one of the people that has spent a great deal of time with all of your investments in Marsico Capital and understanding the depth of that market. And the pent-up demand that exists there among the 300 million Chinese who are experiencing upper middle class and beyond wealth in that country, that is not to minimize the fact that China faces great challenges for almost 1 billion people or maybe over 1 billion people who have yet to experience such prosperity. But we have to keep in mind that this explosive growth in China and the desire for a consumer experience, and incidentally to a great extent it is encouraged by the government, which is trying to enhance the consumer economy in China. So it is not considered improper to want to aspire to the good life. And to Chinese people, part of the good life is going to Macau and partaking of all of the excitement and activities that take place there. Not just gambling, but shopping and fine service and dining and branding is very important to those people. So we’ve learned that over the years here in Las Vegas. When we opened Mirage, we got all that business away from Caesars because we were the newest greatest thing. When we opened Bellagio, the Chinese business immediately switched to Bellagio. When we opened Wynn we had big-time Asian baccarat business because we were the newest and fanciest thing. The Asian market is very, very aware of the top brands, and that’s why we’re so meticulous in making sure that we meet that demand. For example, it is non-productive for us to appeal to the low-end market in China, because the government does not encourage the low-end of China to go to Macau. They don’t mind if people who can afford it go and gamble but they’re sensitive to people who can’t afford it going across the border to Macau. That’s why they pulled back on the visas. But for those people in Hong Kong and South China from [Dagen] Shanghai who can afford the good life, there’s no stigma attached to that in China. And there are so many of them. The market is so deep and rich and successful people who are in search of the good life that Macau is a natural place and Hong Kong and Macau are natural markets to absorb some of that energy. And we are experiencing it along with the other operators in Macau. We’ve maintained our niche in that market because we protected our brand. Encore was more of the same. And coupled with that, we stay on the good side of the government by attending very carefully to a proper Chinese protocol, which is to be humble as a guest of that community, to be grateful for being allowed to be there, and to show our appreciation in every way possible for that privilege including going public on the Hong Kong exchange to increase our Chinese ownership of our company. Those things have all conspired to produce a result along with the natural flow of people across the borders that have affected all the operators to protect our market share and allow it to grow. And in respect to that Tom, there’s one final point I would make, one young analyst several months ago said, ‘Mr. Wynn, as these hotels have opened, your market shares has gone from 17% to 14% or 15% or 13%.’ And I said, well naturally, when thousands upon thousands of tables are added to the market, our market share would drop in terms of gross revenue. But when you’re analyzing and evaluating a gaming company; whether it’s in the United States or in Asia, the right number is not market share in terms of gross dollars, it’s what percentage of revenue per table you have over the ratio of 1 to 1 that you would have if your revenue equaled the same percentage as the amount of tables you have, or to simplify that if you had 10 hotels each with a 100 tables, they would each do exactly the same amount of revenue than the percentage of tables and the percentage of revenues would be equal. That would be total parity. The ratio of revenue to equipment would be 1 to 1. If the ratio of revenue to equipment is greater than 1 to 1, then you operated a more efficient and more positive way than your neighbors. And as more hotels have opened in Macau, our ratio has grown, not shrunken. And that’s the number, that’s the number, the win per table compared to the percentage of tables, the percentage of revenue you have compared to the percentage of tables you have, and in that respect, our market position has improved, not slackened. Those are the things Tom that come to my mind as I think of this subject. Matt, do you have anything to add to that?"

Then later, this, again from Steve Wynn:

"I think there is one another point that Linda and I have discussed that’s worth sharing with all the people on the conference call. The goal of broadening and bringing in new concessions in Macau in 2002 was to broaden the appeal of Macau in the Pacific Rim and around the rest of the world to bring new customers, not just baccarat players into the marketplace. And it is fascinating to see exactly how that process works. So I’m going to explain it with regard to Encore. Macau has junket operators that have a budget that we give them a fixed amount of money to pay for their complementaries for their customers in their rooms, unlike the Las Vegas method which just sort of pays for the rooms. There the house pays for the rooms. Now when we built the Wynn Hotel in Macau, we did what a normal hotel operator does. We built a very commodious large generous typical room at 626 square feet. That’s bigger than Bellagio and the same as Wynn America. And then we built extravagant suites starting at 1,800 feet and going up to 3,000. And those rooms were priced at 200 odd dollars, and the suites well above $1,000 as you would expect in any hotel operation including Shanghai and Hong Kong and Tokyo. And that’s what we did as hoteliers. In the hospitality business, it was very, very normal, right up the middle. The junket operators came to us, they came to Linda actually and said just a minute, that’s not what we need. The typical room is beautiful, but it’s not sexy enough for a gambler, and the suites are too expensive for us to waste all of our money at $1,500 or $1,200 a night. What we want is a very theatrical and beautiful room that we can buy for under $400, preferably at $350. Well, there was no such product. And all of a sudden the pressures exerted by gambling interests caused us to create a product an 1,100 square foot suite. We went and did it, and that is Encore. Now what we have done is built a room that is at $350 the most incredible piece of hospitality real estate in the world. And it has an enormous appeal to everybody, especially non-gambling people, because it represents the greatest bargain in the world. So now here’s Macau, creating a product from its organic gambling roots that now changes the city and the market to be more appealing, more broad-based in its attractiveness to everybody. How interesting unintended consequences are or maybe they are intended, but here is a product that was engendered by gaming requests that becomes a non-gaming plus for the city. The most lovely room in the world at a price that is almost half of what a regular room at the Peninsula costs, which would be less than half its size. Interesting how things work. I call that, and I’ve made this point to the government, organic growth. That is not the same thing as trying to pick up Las Vegas and drop it on Macau that will never work. One is China, one is the United States, and China is China is China, and in relationships with the people of that country, in relationships with your employees, you must not forget that it is not Las Vegas, it is not America. And so dropping Las Vegas strip into Macau was always an idea that did not respect the basic fundamental notion of Macau. And so we try in our observation of the people, what we’ve learned since ‘06. We could never have built Encore Wynn in ‘06. We did not have the hands-on experience with the customers. We learned from our customers, as all good businesses do, we learned from our customers and our employees, how to better run our business. And so what we have in Encore Macau is an organic product that grows in Macau out of the soil of Macau’s own beginnings. And I’m glad that that question was asked Robin, because it gives us a chance to clarify what we’ve done. And I hope that adds some color to your question."

That's a free lesson in how to think about the hospitality industry, courtesy of Steve Wynn's expert view.  Again, I think he expresses these concepts better and more openly than any other CEO I've ever heard.

Getting away from the earnings call transcript, and back to the earnings release itself, there were a few interesting items.  The Las Vegas results: 

"Net casino revenues in the first quarter of 2010 were $139.5 million, up 18.8% from the first quarter of 2009. Table games drop was $556.9 million compared to drop of $520.0 million in the 2009 quarter and table games win percentage of 23.2% was within the property’s expected range of 21% to 24% and higher than the 17.7% reported in the 2009 quarter."   

In plain English, earnings were up vs the same period last year, but that's largely because 2009Q1 was, to put it bluntly, somewhat "unlucky" for WYNN - their win percentage in 2009Q1 was 17.7%, vs 23.2% in 2010Q1. Table games drop was only up 7%.

Then, the doozy:

"Gross non-casino revenues for the quarter were $225.2 million, a 1.4% decrease from the first quarter of 2009, driven primarily by lower hotel revenues which were partially offset by higher entertainment revenues.

Hotel revenues were down 8.8% to $77.6 million during the quarter, versus $85.1 million in the first quarter of 2009 as Average Daily Rate (ADR) decreased 8.6% to $203, compared to $222 in the 2009 quarter. Our occupancy was 89.4%, flat with the 89.5% generated in the prior year period, generating revenue per available room (REVPAR) of $181 in the 2010 period compared to $199 in the first quarter of 2009.

Food and beverage revenues decreased 1.0% to $95.9 million in the quarter and Retail revenues were $18.9 million in the quarter, 3.3% below last year’s levels."

I wrote a post last week asking for anecdotes from my readers regarding economic recovery.  I interpret WYNN's Las Vegas results as a clear sign that the Vegas economy is certainly not recovering - the numbers continue to deteriorate, even from Q1 2009's miserable levels.

-KD

Back to Business, I Guess

I wrote a post about my new foster dog who wears a diaper and is supposedly trained in German, and it generated not a single comment!  I guess you guys want to talk about Greece instead, so here it is, from David Rosenberg via TPC:

“First we have governments bailing out banks (and auto companies and mortgage providers), homeowner debtors, and now we have governments bailing out governments.  When does someone finally say — enough is enough!

Oh no — bank ABC is too big to fail.  Company XYZ is too complex to fail.  And now country GRK is too interconnected to fail.  Give me a giant break.   Look, Greece is not going to “fail”.  They are going to default.  There will be a debt restructuring.  And there will be some recovery.  Bondholders will take a haircut — why shouldn’t they?  Why should Angela Merkel care if German banks own Greek bonds?  Greece has been in default in its recent 200-year history almost half the time.  So has most of Latin America come to think of it.  What about Russia?

So Greece defaults, bondholders who knowingly bought these instruments knowing the historical record went for the yield and simply do not deserve a taxpayer supported bailout of any kind.  To actually come to the aid of Greece (especially after all the accounting gimmickry) would send a signal to investors that the best way to make money is buy the debt of the most risky and highest yielding enterprise because there will always be a bailout.  Rewarding bad investment decisions is a huge mistake, in my opinion.

Let Greece default, the world will not come to an end, and whether or not the country gets a “bailout”, the fiscal drain is going be a pervasive drag on economic activity for at least the next five years.  While there may be contagion risks — same deal.  Investors who bought Club Med bonds with their stretched government balance sheets in order to stretch for yield don’t deserve to be bailed out either.

Taxpayers unite, wherever you live (because you too support the IMF).  These are solvency issues we are talking about, not liquidity issues.  This is about bad decisions, not market failure."

Also worth reading from TPC:  Americans are once again bailing out banks via Greece.

"Most Americans probably haven’t connected the dots yet, but you’re going to be signing an enormous check over to Greece over this weekend.  That’s right, as the largest contributor to the IMF the United States taxpayer is on the hook for the Greek bailout.  The numbers aren’t set in stone quite yet, but the latest rumors are for a $160B bailout over three years.  Of course, the most despicable part of this whole thing is not just the fact that the U.S. is helping to bail out Greece, but that this bailout is actually another bank bailout!  That’s right.  This isn’t really about the people of Greece.  They are going to be forced into years of austerity and painful economic times regardless of the situtation.  What this is really about is the $189B in Greek debt that the European banks have on their books.  No one wants them to take a 70% haircut on the debt.  So, connecting the dots here for you – Americans are once again bailing out banks – this time via the IMF."

-KD

Meet Mr. Griffey!

So a few weeks ago I mentioned that Mrs. Dynamite had filled out the application to be a foster home for the National Brussels Griffon Rescue.  We were excited last week to get a phone call that they already had a dog in need of a foster home.  Here's what we were told: Mr. Griffey is 4 years old, not neutered, and is being given up by an elderly woman.  The previous owner reportedly tried to sell Mr. Griffey because he was lifting his leg in the house (which contained a few "intact" females), and the NBGR coordinator saw the ad and, after significant back and forth, convinced the owner to give the dog to the rescue organization, who would ensure that it ended up in a good home.  Mr. Griffey, we were told, weighed 10 pounds, had been trained as a therapy dog, and was a cutie.  And no - he's not named after Ken Griffey Jr. - he was clearly given the generic Brussels Griffon name - it's like naming a golden retriever "Goldy." It's horrible, but we'd later find out that he responds to it a little, so we didn't want to change it.

Mrs. Dynamite and I were pretty excited, and I was pretty nervous at the thought of a dog running rampant all over my new house peeing on everything.  Mrs. Dynamite was nervous that Oscar, her true love, wouldn't like Mr. Griffey.  We've been wanting to get a second dog for a while, but obviously we wouldn't have to keep Mr. Griffey if he didn't fit in with our pack.  Our goal was to get him neutered, train him up a little, and then adopt him out if he's not a good fit for us.

So anyway, we journeyed to the rescue coordinator's house in suburban Boston on Sunday evening.  She has a pack of 8 of the most ragtag pooches you've ever seen:  3 are blind, 1 is missing an eye, they're almost all old, they are yippy and yappy, but they were very sweet too.  That's why she wanted to place Griffey elsewhere, since he was so young and might have a more active life than her slower paced pack.  We entered her house, and I immediately sat down on the floor, trying to attract Mr. Griffey, who was showing some fear.  He'd been moved to the coordinator's house only a few days before, and he was already smitten with her.  Griffey ignored me, but two of her other Griffs jumped right into my lap and snuggled in, as she explained that the breed was notorious for being aloof towards men, but that these two had had a male owner previously.  I'd never heard that about the male aloofness, but anyway...

The coordinator explained why Mr. Griffey was wearing a "belly band" - because he was lifting his leg everywhere attempting to mark his territory.  The belly band is a piece of fleece with velcro on each end, and a maxi pad in the middle of it.  Yeah - it's a pee diaper for male dogs.   This is my life.

She thought that the prior owner, who, it turns out, was not an old lady at all, had been breeding him.  Strangely, for a stud, Griffey was super submissive.  He immediately conceded that Oscar was the top dog.

"Oh - there's another thing,"  she told us, "he's trained in German."

I looked around for the hidden cameras and chuckled.  She was serious.  She continued,

"I think the command for sit is "SPETZEN"  (turns out, it's not - this is my new bible: The list of German dog commands) "But I don't know the release command. Supposedly when you put him in a down-stay he'll stay there for a half hour if you don't release him!"

Hmmm.. So we have a German speaking dog, and I'm not sure which commands he knows, and he wears a diaper!  But he's WICKED cute.  Anyway, we took him home, with Mrs. Dynamite riding in the back with both dogs for the 1:45 trip back to NH.

Arriving home, we took Griffey and Oscar for a walk, and then they played really well together on the floor.  We went for another walk, but Griffey still refused to poop, so we went to bed.  He was very restless in bed, likely the result of having been moved to a new home again, and we knew he had a peeing problem, so at 3:30 in the morning, I decided I'd take him out again, just to avoid a potential issue with a bed pooping incident. Yeah - we let him sleep in the bed, just like Oscar.

Now, the whole family comes, and we're walking down the street at 3:45 am, with flashlights, cooing in a German Grandmother's accent, "Mister Griffey, SCHEISSE!"  This made me laugh my ass off - the thought that a) this dog would poop on command, and that b) I knew the codeword!  Needless to say, it didn't work.

Mr. Griffey took an immediate liking to my wife, who he instantly adopted as a surrogate mother.  He's not crazy about me, but is ok with me when she's around.  When she leaves, I can't even get him to take treats from my hand. It's like he's terrified of me when we're alone.  We have no reason to believe he'd been abused previously, so hopefully he just needs some adjusting.  

Oscar: left, Griffey: right, politely begging for food at dinner.  Griffey is "tethered" so he can't wander off and lift his leg - although he didn't attempt to mark at all for 2 days, so we took the tether off.

Today, I went to the dump, and when I came back, the dogs were barking their heads off, as they usually do when someone comes to the house.  As I walked in, I heard Mrs. Dynamite yelling, "Mister Griffey:  NEIN!"  and I couldn't help but smile at the absurdity of it all.

We love our little diaper wearing German dog, although Mrs. Dynamite said he didn't react at all when she played that video for him, which is consistent with his non-reactions to our German commands, so he probably doesn't speak so much German after all.

Griffey showed a little bit of toy-possessiveness, snapping at Oscar when he tried to play tug of war, and growling at me.  He didn't mind if my wife grabbed the toy, though.  Oscar ignored him all day yesterday, but they played well this morning outside, and hopefully Griffey just needs some time to get settled.

You can be sure that further updates will follow.

If you'd like to donate to the National Brussels Griffon Rescue, you can do so here.

-KD

Censorship Will Solve Nothing! You Hear Me BNP?

I've been informed that BNP Paribas has blocked access to blogspot URLs from their servers.  That means that employees of the French bank can no longer enjoy my blog nor many others.  EFF YOU BNP!

some things to read (some are old):

Cliff Asness: Keep the casino open

Roger Lowenstein's NY Times Op-ed: "How Wall Street Became a Giant Casino"

Alea: Abacus for dummies

Bethany McLean's NY Times Op-ed: "Meet the Real Villain of the Financial Crisis"

Reader JonW's comment on Steve Waldman's recent post:

"Probably where many of the differences of opinion form is whether or not we think of offerings as market making activities or as some kind of “sale/promotional.” I think the diffculty in this discussion is that for most people when they see a pitchbook or a sale of offerings, they think of it coming from an advisory standpoint. People find the behavior appalling because the assumption is that the sales function of goldman and other banks is to present you with things that will be “good” for you and make you risk adjusted money. That is a perfectly reasonable view to have and I would be appalled too if I had that view.

From my perspective and the perspective of GS, their function is not to make you money. At least not in respect to trading, market making and even offerings. The presentations, pitchbooks etc simply exist to tell you “this is what you will be buying, and this is a price at which you can buy it for.” In theory the IPO prices in an offering are supposed to be values that reflect a neutral point between the sellers and buyers. Even here there is an adversarial relationship. Sellers want more, and buyers want less.

As much as GOLDMAN doesn’t want to admit it, most of their operations are as bookies not as advisors. And being a bookie isnt a bad thing. Lots of professions do basically the same thing. A real estate broker is no different. They’re just guys that know the process , collect a fee and and set some lines.

It’s why you heard GS execs saying they sold exposure, not returns..."

and related to that comment, from the NY Times' live blog of the hearings, this explanation of why Senator Levin and Lloyd Blankfein seemed to be speaking different languages:

"What you’re witnessing here is an essential debate over the components of Goldman’s business. As Dan Sparks explained earlier, Goldman both creates new investments (like C.D.O.’s and mortgage bonds) and it provides so-called market making, which is like the air-traffic control room of assets. As a market-maker, Goldman trades assets that were already created. And so Mr. Blankfein’s remarks on market-making and the senator’s remarks on investments created by Goldman are floating past each other like cars headed in opposite directions."

I don't really want to debate the GS hearings, but I do think that Senator John McCain's questioning was an embarrassment to himself and his role.  McCain showed up late in the day, asked ignorant questions that were a complete waste of time (like asking for an explanation of what a CDO was), demonstrated a complete lack of understanding of what the SEC suit vs GS is about, and, of course, threw in some populist references to the ails of community banks.  Hey Senator McCain - do you know why community banks are going out of business?  It's because they made bad loans!  I know! Hard to believe that, right? 

-KD

Goldman Sachs Senate Testimony: City Deal vs City Wok

Levin's "shitty deal":



(via Clusterstock)

vs  South Park's City Wok:




If you watched the hearings this morning, you MUST read Bess Levin's sarcastic liveblogging recap of the proceedings.  If Bess's recap doesn't make you laugh, you need to get your sense of humor checked.

-KD

It's Time For Your Anecdotes

When I lived in New York City, I had my ear to the ground.  I wouldn't say that NYC is typical of the national economy, but at least I was getting out, seeing activity, seeing people waiting in line to pay $15 for a drink and $40 for an entree, or seeing stores closing when economics didn't keep up with soaring rents, etc.

Now, living in the woods, I have to admit, I have absolutely NO first hand sense of what the state of our economy is.  The trees still bloom, the grass still grow, the horses still graze.  "They" tell me that economic data suggests some signs of recovery, but I can't fathom how the average American can recover when 1) jobs are scarce and 2) the home-as-ATM model which fueled the middle of the last decade is dead.

I go to Lowes, Hannafords and Sam's Club on a regular basis, but perusing these Concord hot spots doesn't give me a sense of the status of the economic recovery:  if I go at noon on a Tuesday, they are empty. If I go at noon on Saturday, they are busy.  I'd hesitate to draw any conclusions from that.

I was home visiting my Dad this weekend in suburban Boston.  There is a little store in the little "downtown" area of his town that is PRIME retail space.  It's been vacant for 18 months now, I think, and is still vacant.  To me, that's one sign that not everything is "solved."  If I lived in my dad's town, I'd rent that spot in a heartbeat for a retail opportunity.  I even called the landlord last time I was home to ask about the rent.  Let me put it this way:  layup.

So, readers - I want your anecdotes.  What are you seeing?  Do you go to the mall and drive around for 25 minutes looking for a parking space because it's so crowded?  Are you unable to get into restaurants for dinner because everyone is out spending money?  Give me your channel checks from across the country!

CNN has a little 6 pack of slides today titled "My Recession is Over," with a handful of stories about people who say things are doing better.  One of the front page Bloomberg stories I saw today was trumpeting how stocks are "cheaper now than at any time in the last 20 years."  Of course it's no coincidence that the two mangers quoted in the article as talking about how cheap stocks are happen to manage two massive money management firms who NEED you to buy stocks.  For me, the truth remains: profits look good because government spending has replaced consumer spending.  That's no model for the future...

A related must read is Jeremy Grantham's quarterly letter about the latest series of bubbles the Fed is blowing, and how it all might end...

leave me your anecdotes in the comments - are you refinancing?  are you buying a house?  making big purchases?  how are negotiations with the banks in all of these transactions?

-KD

Greece Gun: FAIL

I guess the markets weren't intimidated by Greece's loaded gun...

From Bloomberg:

"Greece called for activation of a financial lifeline of as much as 45 billion euros ($60 billion) in an unprecedented test of the euro’s stability and European political cohesion."

If you recall, as I wrote about 11 days ago, Greece attempted to used the "bazooka" defense to lower their borrowing costs, hoping that the THREAT of a bailout would be enough to placate their lenders into accepting lower yields.  Just like Hank Paulson's 2008 bazooka attempt with FNM and FRE, this one failed miserably.

EDIT: RELATED:  from the Reformed Broker on stocktwits, via Howard Lindzon:

"Dear China, can you please just buy Greece already so we can move on?  Thanks, Rest Of World"

-KD

FDIC Deposit Insurance: A Blast From The Past

I'd be surprised if anyone thought that banks would be happier without deposit insurance these days.  We (they!) need deposit insurance to avoid panic and bank runs when depositors get nervous, and we need it now more than ever because of the highly suspicious state of the banks' balance sheets, and the increasingly levered nature of our financial world (compared to that of prior generations).

Thus, I found Paul Kedrosky's link today, to the 1933 TIME magazine reaction to the initial instituting of deposit insurance, to be fascinating (emphasis mine):

"Through the great banking houses of Manhattan last week ran wild-eyed alarm. Big bankers stared at one another in anger and astonishment. A bill just passed by both houses of Congress would rivet upon their institutions what they considered a monstrous system of guaranteeing bank deposits. Such a system, they felt, would not only rob them of their pride of profession but would reduce all U. S. banking to its lowest level. They saw their deposits which they had spent a lifetime to build up and protect with their good names confiscated by the Government to pay for the mistakes and dishonesty of every smalltown bankster."

Amazing, isn't it?  Initially, the bankers hated the insurance, because they had worked hard to build up their reputations for excellence, and the insurance leveled the playing field so that every bank could simply buy the equivalent of that reputation by paying a small fee to the FDIC.  Moreover, the big banks felt they didn't need to pay the fee, because they didn't need the insurance in the first place - they viewed it as a confiscation of both their reputational and monetary wealth to redistribute to the smaller banks!

My how times have changed...

-KD

disclosures:  short XLF, long insured deposits

Big Boston Sports Night

Tuesday, the Red Sox broke out of their slump with a walk off win thanks to unknown newcomer Darnell McDonald.  The Celtics, without their emotional leader Kevin Garnett, destroyed the Heat in Game 2 of the NBA playoffs first round.

Wednesday, the Bruins, coming off back to back wins against Buffalo in the NHL playoffs first round, hosted Buffalo, while the Red Sox were home against the Texas Rangers.  Buffalo sported an incredibly regular season stat:  they were 30-0-0 when leading after two periods - they had not blown a lead after 2 periods for the entire regular season.  Boston already had one come from behind win in the playoff series, and came back from down 2-0 in the third period of game 4 to tie the game.  They played halfway through the second overtime before Boston finally scored the game winner to take a commanding 3-1 series lead.

I took the dog for a walk, walked into the house, and sat down to watch Kevin Youkilis's game winning walk off hit for the Red Sox in the bottom of the 12th inning.  Two in a row for the Celtics, Three in a row for the Bruins, including a double overtime win and two third period comebacks, and 2 walkoff wins in a row for the Red Sox.  Good times.

The save made by Bruins' goalie Tuukka Rask halfway through the 3rd period was absolutely INSANE.  Hopefully this video doesn't get taken down:

In other sports news - I respect this prank the Atlanta Braves played on Nate McLouth: McLouth hit a walk-off homer, but instead of mobbing him at home plate, his teammates ran into the clubhouse as soon as he hit the ball, so he circled the bases alone and returned laughing to an empty dugout.  Nice move, Atlanta.

-KD

GM - Reading the Whole Story

A friend of mine sent me the GM press release today, amazed that they'd "paid back the government" in full and ahead of schedule.  Wow. That would be pretty amazing.  Let's go to the release:

"General Motors Company Chairman and CEO Ed Whitacre today announced that GM has made its final payment of $5.8 billion to the U.S. Treasury and Export Development Canada, paying back its government loans in full, ahead of schedule..."GM is able to repay the taxpayers in full, with interest, ahead of schedule, because more customers are buying vehicles like the Chevrolet Malibu and Buick LaCrosse we build here in Fairfax," said Whitacre. "We are now building some of the best cars, trucks, and crossovers we have ever built, and customers are taking note.  Our dealers are increasing their sales, we are investing in our plants, and we are restoring and creating jobs."

Of course, what the GM press release doesn't make any mention of are the details:

"GM got a total of $52 billion from the U.S. government and $9.5 billion from the Canadian and Ontario governments as it went through bankruptcy protection last year. At first the entire amount of U.S. aid was considered a loan as the government tried to keep GM from going under and pulling the fragile economy into a depression.

But during bankruptcy, the U.S. government reduced the loan portion to $6.7 billion and converted the rest to company stock, while the Canadian governments held $1.4 billion in loans. Those loans were repaid Tuesday, five years ahead of schedule.

The automaker hopes to repay the remaining $45.3 billion to the U.S. government and $8.1 billion to Canada via a public stock offering, perhaps later this year. The U.S. government now owns 61 percent of the company and Canada owns roughly 12 percent."

So just to be clear - the US Government gave GM over $50 BILLION dollars, and GM promptly declared bankruptcy, wiping out most of this "debt," save for $6.7B of it, and converting the rest to equity.  Then, GM paid back this $6.7B in "loans," and the US Government is left holding 61% of GM's equity.  It's probably a little bit of a stretch to say that GM has paid back its government loans in full...

The Government also still owns $2.1B in GM preferred stock.

-KD

SEC vs GS: Just When I Thought I Was Out...

They pull me back in!

I'd be remiss if I didn't republish this story: "Testimony Could Undercut SEC Charge Against Goldman".  For those unaware, Paulo Pellegrini is a former Paulson lieutenant who left to start his own hedge fund.

presented without comment, emphasis mine:

"The government has testimony from a Paulson & Co. official that could contradict its own claims against Goldman Sachs, CNBC has learned.

Paolo Pellegrini told the government that he informed ACA Management that Paulson intended to bet against, or short, a portfolio of mortgages ACA was assembling. 

If true, the testimony would go directly against government claims that ACA did not know Paulson was hoping the collateralized debt obligations would fail, and subvert charges that Goldman breached its duty by not informing ACA of Paulson's position.

CNBC has examined documents in which a government official asked Pellegrini whether he informed ACA CDO manager Laura Schwartz about Paulson's position.

"Did you tell her that you were interested in taking a short position in Abacus?" a government official asked Pellegrini, referring to the name of the CDO portfolio.

"Yes, that was the purpose of the meeting," Pellegrini responded.

The exchange is key in that the Securities and Exchange Commission is charging that the failure to disclose Paulson's position was a "material" factor that could have caused both ACA and German Bank IKB to back out of the CDO investment. When the CDO failed, Paulson reaped a gain of more than $900 million, the government has said.

The SEC does not mention the exchange in its complaint against Goldman.

"We look forward to presenting a complete and accurate evidentiary record in court," SEC spokesman John Nester said in a statement to CNBC."

-KD

Disaster Averted

Phew... The doormen of New York City, who actually have their own union, narrowly averted going on strike last night.  The NY Times tells us how bad the consequences of such a strike could have been:

"If the doormen and other service workers had gone on strike, residents of the affected buildings would have had to perform their own chores, like sorting mail, screening visitors, hauling garbage out to the curb and operating elevators."

NOOOOOOO!!!! THE HORRRRRROR!  Sorting mail?  Are you out of your mind?  OPERATING MY OWN ELEVATOR?!?!?!  DYKWTFIA?!?!?

I actually talked to a buddy of mine last night who told me about this potential strike.  He said "Dude - if the doormen strike there will be chaos - we'll have to haul our own trash to the curb."   

"Umm, bro,"  I responded, "hauling your trash to the curb isn't quite the definition of chaos."

Not to worry - there would have been rent-a-cop security in place, which is the only real concern.

There are some more gems in the article, like this:

"In the hours before the strike deadline, others were dreading a disruption in the don’t-do-it-yourself lifestyle of calling the super and ordering in Chinese that is particular to urban apartment dwellers. 

“It would definitely be a big inconvenience,” said Nicole Auerbach, 36, who lives on West End Avenue. “Our doormen told me probably 50 percent of the people in our building have takeout delivered on any given night.”"

oy vey.  Look - I'm fine with taking my trash to the curb and operating the elevator, but if you infringe upon my right to get Chinese takeout delivered, you will feel my wrath.  It is absolutely positively insane to think that the Chinese takeout man might have to call me from his cell phone from outside my building and that I might have to come down and get it at the curb from him.    Do we look like animals to you?  We are CIVILIZED human beings - and civilized human beings have their Chinese takeout delivered directly to their apartment doors.

-KD

CSI: New Hampshire Woods

I'm sick of writing about Goldman Sachs - I have bigger issues to deal with - like finding out what varmint is nibbling on my new apple trees!

I planted two beautiful apple trees and one peach tree last week, and laboriously carried buckets of water to them to nuture them.  I was away for the weekend, and came back to find that someone appears to have eaten off several of the buds.  

Now, here are the facts:  1) several of the buds/branches are cleanly snipped  but 2) there are plenty of buds/branches left - why didn't they all get eaten?  3) I found a deer hoof footprint in the mud around one of the trees today, but 4) I also found what appears to be bird crap on one of the branches...

So is it a bird, or a deer?  or something else?  I'm guessing deer.  I also found some mysterious poop on another part of my property today, about 100 yards from the apple trees.  It looks like the kind of dump Oscar would take, but I'm 90% sure it's not him.  There were two little piles a foot apart, and the poop looked to be several days old.  Hmmm...  fox?  coyote?  porcupine?

Then there's another foe I'm declaring war on:  dandelions!  I have a beautiful lawn, and there are some dandelions starting to sprout up in it.  "Kid Dynamite, use the anti-weed fertilizer," you say.  But wait - I can't do that - my lawn has a lot of "bent grass" in it, and you can't really use any of the weed-inhibiting fertilizer on bent grass.  I put down Scott's Turfbuilder last week, and I guess the dandelions loved it, because I started seeing them a few days later.   I started digging out the dandelions with a trowel yesterday, but quickly stopped because i was trading the offending weeds for sizable holes in my lawn, which wasn't really helping.

Today, I went to Lowes and bought the dandelion-remover, which looks like a narrow-forked BBQ fork.  This is my life.

-KD

Goldman Responds AGAIN to the SEC's Suit

Via WSJ's DealJournal comes Goldman Sachs's third response, presented here in full, without comment:

Overview:

On Friday, April 16, the US Securities and Exchange Commission brought a civil action against Goldman Sachs in relation to a single transaction in 2007 involving two professional institutional investors, IKB and ACA Capital Management (ACA). We believe the SEC’s allegations to be completely unfounded both in law and fact, and will vigorously contest this action.

The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility.

Goldman Sachs would never condone one of its employees misleading anyone, certainly not investors, counterparties or clients. We take our responsibilities as a financial intermediary very seriously and believe that integrity is at the heart of everything that we do.

Were there ever to emerge credible evidence that such behavior indeed occurred here, we would be the first to condemn it and to take all appropriate actions.

This particular transaction has been the subject of SEC examination and review for over eighteen months. Based on all that we have learned, we believe that the firm’s actions were entirely appropriate, and will take all steps necessary to defend the firm and its reputation by making the true facts known.

The SEC does not contend that the two professional institutional investors involved did not know what they were buying, or that the securities included in this privately placed transaction were in any way improper. These institutions were very experienced in the CDO market. 

In this private transaction, Goldman Sachs essentially acted as an intermediary, helping to facilitate the investing objectives of two clients. Extensive disclosures as to each of the securities in the reference portfolio, similar to those required by the SEC in public transactions, were contained in the offering documents which provided all the information needed to understand and evaluate the portfolio.

In the process of selecting the reference portfolio, ACA Capital Management, who was both the portfolio selection agent and the overwhelmingly largest investor in the transaction ($951 million, with the other professional investor’s exposure being $150 million), evaluated every security in the reference portfolio using its own proprietary models and methods of analysis. ACA rejected numerous securities suggested by Paulson & Co., including more than half of its initial suggestions, and was paid a fee for its role as portfolio selection agent in analyzing and approving the underlying reference portfolio.

In summary, the SEC’s complaint is an issue of disclosure on a single transaction involving professional investors in a market in which they had extensive experience. Critical points missing from the SEC’s complaint include:

Goldman Sachs Lost Money on the Transaction. The firm lost more than $90 million arising from this transaction. Our fee was $15 million. We certainly did not wish to structure an investment that was designed to lose money.

Objective Disclosure Was Provided. The transaction at issue involved a static portfolio of securities, and was marketed solely to sophisticated financial institutions. IKB, a large German Bank and leading CDO market participant and ACA Capital Management, the two investors, were provided extensive information about those securities and knew the associated risks. Among the most sophisticated mortgage investors in the world, they understood that a synthetic CDO transaction requires a short interest for every corresponding long position.

Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint in part accuses the firm of potential fraud because it didn’t disclose to one party of the transaction the identity of the party on the other side. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was to be a long investor.

ACA, the Largest Investor, Selected and Approved the Portfolio. The portfolio of mortgage backed securities was selected by an independent and experienced portfolio selection agent after a series of discussions, including with IKB and Paulson & Co. ACA had an obligation and, as by far the largest investor, every incentive to select appropriate securities.

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson could benefit from a decline in the value of the underlying reference securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, could benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager. As of May 31, 2007, ACA was managing 26 outstanding CDOs with underlying portfolios consisting of $17.5 billion of assets.

IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities (RMBS), which it stood behind as the portfolio selection agent and the largest investor in the transaction.

The offering documents for the transaction included every underlying reference mortgage security. 

The offering documents for each of these RMBS in turn disclosed detailed information concerning the mortgages held by the trust that issued the RMBS.

Any investor losses resulted from the massive decline of the broader subprime mortgage market, not because of which particular securities ended up in the reference portfolio or how they were selected.

The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs retained a substantial long position in the transaction and lost money as a result.

Questions and Answers

Who were the investors in this transaction?
The investors in the transaction were ACA Capital Management, a well-recognized collateral manager and investor in CDOs, and IKB, then believed to be one of the most highly-sophisticated CDO investors in the world.

What is a synthetic CDO?
A synthetic CDO has characteristics much like that of a futures contract, requiring two counterparties to take different views on the forward direction of a market or particular financial product, one short and one long. A CDO is a debt security collateralized by debt obligations, including mortgage-backed securities in many instances. These securities are packaged and held by a special purpose vehicle (SPV), which issues notes that entitle their holders to payments derived from the underlying assets. In a synthetic CDO, the SPV does not own the portfolio of actual fixed income assets that govern the investors’ rights to payment, but rather enters into CDSs that reference the performance of a portfolio. The SPV does hold some separate collateral securities which it uses to meet its payment obligations.

What are the implications of this SEC action for the overall CDO market?
The SEC complaint is related to a single transaction in 2007 and involves a highly particularized set of alleged facts. It would not appear to have broad ramifications for the CDO market generally.

Who selected the securities that ended up in this particular portfolio?
ACA had the sole right and responsibility to select the portfolio and it in fact did so. As part of the process, ACA received input from other transaction participants. ACA had served as portfolio selection agent or collateral manager for numerous other transactions, and no doubt was accustomed to an interactive selection process. ACA used its own expertise and models in scrutinizing and approving the referenced securities. ACA subjected the securities proposed for inclusion in the portfolio to its own proprietary models and analysis.

What is the firm’s role in facilitating such transactions?
Goldman Sachs acts as a market intermediary through which its clients can take long or short positions on the reference securities. Goldman Sachs will often assume the opposite side of a client’s position to complete a transaction. As fully disclosed to investors in the offering materials in this transaction, the firm can then hold or sell that position to increase, reduce or eliminate its own exposures.

Did investors have adequate disclosure?
Extensive, objective disclosures were contained in the offering documents. Investors had all the information they needed to understand and evaluate the reference securities.

What was the role of ABN Amro / RBS in this transaction?
ABN intermediated a $909 million credit default swap referencing the portfolio between Goldman Sachs and ACA. ABN assumed the credit risk that ACA might not be able to pay if its obligations under the credit default swap came due. When the portfolio suffered writedowns, ACA ultimately was not able to pay the amount due on the credit default swap, and ABN made payment.

-KD

Goldman Commentary Linkfest - Blaming Paulson?

Goldman Sachs & The Truth, The Whole Truth, and Nothing But The Truth.  If you're not clear on where I stand on this, read my post and the comment thread also.

Baseline Scenario's Simon Johnson:  "John Paulson Needs a Good Lawyer."  I put this link first (behind my own, of course) because I find it COMPLETELY preposterous.  I don't like to give pixels to arguments that I find completely insane and without merit, but Johnson is not a fool, and he's not a lunatic hypster, so I found this post to be incredibly odd.  Maybe someone hacked into his account, but I doubt it, because he went on Bill Maher to advocate the views he has in this piece.  Johnson writes: 

"Here’s the legal theory to keep in mind.  Mr. Paulson only stood to gain on a massive scale (or at all) if the securities in question were mispriced, i.e., because their true nature (that they had been picked by Mr. Paulson) was not disclosed.  In other words, the Paulson transactions at this stage of the game only made sense if they involved fraud."

Well, that's not even close to being CLOSE to true.  Paulson stood to gain because he did the work to value the securities in question, knew there were major risks, and knew that others didn't know they were major risks.  He knew that everyone from the people on the other side of the trade to the ratings agencies were completely clueless as to the mispricing of risk, and profited from it.  In fact, my exact point in the comments of my earlier GS Fraud threads was pretty much exactly the opposite of Johnson's claim - my point was that the fraud doesn't really change the end result (the ignorance on the part of the buyers which resulted in their gross mis-assessment of the risk) at all.    Johnson's final conclusion is:

"Mr. Paulson should be banned from securities markets for life.  If that is not possible under current rules and regulations, those should be changed so they can apply.  If that change requires an Act of Congress, so be it."

If Paulson should be banned from securities markets, we should just shut down all securities markets, because Paulson is doing exactly what he's supposed to be doing:  profiting from mispriced securities.  

NY Times:  a profile on Paulson. 

"Robert Khuzami, the director of enforcement at the S.E.C., explained that, unlike Goldman, the manager of the hedge fund, Paulson & Company, had not made misrepresentations to investors buying the security, known as a collateralized debt obligation."

Steve Waldman expounds on the value of information, such as "who is on the other side of my trade."  I voiced an opinion in the comments.  

Leigh Drogen: "Caveat Emptor!" I actually played a little Devil's Advocate in the comments of Leigh's post, but I love this quote from him:

"To those out there in the institutional investing world: It’s time that you start doing some god damn due diligence on the investments you make.  You’ve got to know who’s on the other side of your trade.  No one is forcing you to make any investment, when you sign that contract or push that buy button you’ve got to make sure that you have all the information."

Stone Street Advisors: "On the GS Fraud Charges."  Re: ACA

"Again, while I’m not a lawyer, from what we’ve seen so far, it looks like the investors’ shareholders may have merits to file suit against the firm’s management for breach of fiduciary duty, since its seems pretty clear that both ACA and IKB (and/or others) didn’t come anywhere close to conducting the kind of diligence required prior to undertaking such a transaction.  They were given a list of all the underlying RMBS and could have easily done the same research Paulson & Co. apparently did, but it seems that either they did – and simply had a rosier outlook for MBS/over-reliance on Ratings – and/or didn’t, in which case they have no one else to blame but themselves."

Sam Antar on how the SEC may have trapped GS into responding too hastily. 

-KD

Abacus Irony

Rhetorical question: 

When Goldman Sachs decided to name their series of Collateralized Debt Obligations "Abacus,"  were they laughing to themselves the whole time, chuckling that it was an inside joke because almost no one can actually figure out how to make sense of an abacus?

-KD

Goldman Sachs & The Truth, The Whole Truth and Nothing But The Truth

So there is still a lot to discuss about this Goldman Sachs situation.  I wrote my initial summary and reaction after reading the SEC's complaint.  I found the SEC's logic to be pretty reasonable.  Then, I read Goldman's response, which I also initially found to be pretty sensible.  Now, after more thought, I have found where I think GS erred in its response.  I encourage anyone wishing to have an intelligent discussion about this topic to first read the SEC's roughly 20 page complaint - it's in plain English, not confusing legalese, and will help with your understanding of the issues.

Without doing a line-by-line on Goldman's response, let's take a look at a few key issues:

1) Goldman claims that they lost money on the transaction.  This may be true, but isn't relevant to the SEC's complaint.  The main complaint is that GS failed to disclose material information to the buyers of the synthetic CDO - not that GS took the other side of the trade and profited.  What is odd is why GS was on the wrong side of the trade - that still doesn't make a whole lot of sense to me, considering it seems clear that even if the buyers didn't understand the risks in the underlying reference assets, GS did understand the risks. 

2) GS wrote: "ACA, the Largest Investor, Selected The Portfolio."  This may be the truth, but it's not the whole truth.  We've all seen courtroom scenes on TV where a witness swears to tell "The truth, the whole truth, and nothing but the truth."  At the very least, if Goldman is telling the truth here (which I think, by the letter of the law, they probably are - after all, ACA did select The Portfolio) they aren't telling the WHOLE truth.  ACA did select The Portfolio, but it was from a list that Paulson presented.  I'm not even sure this should matter, since ACA had final say in the portfolio selection.  As commenter UncleFester wrote on Henry Blodget's piece: "Furthermore, there is nothing to suggest ACA did not have the ultimate authority on the composition of the portfolio. If ACA didn't like the portfolio, it was free to pull out of the deal prior to its closing."

3) The always brilliant Steve Randy Waldman wrote a whole post today about GS's claim that "These investors also understood that a synthetic CDO transaction necessarily included both a long and short side."   Waldman's point is that the investors did NOT understand this - but Waldman doesn't make excuses for the investors, only tries to point out that GS's claim that the investors knew this was false.  In my opinion they certainly SHOULD have known this, but they were living in a different bizarro fantasy ignorant world view of the mortgage markets.  I think Waldman errs a little bit in that it doesn't matter than investors didn't know - they SHOULD have known.  Synthetic CDOs are indeed a type of product where the profits one party earns come directly from the counterparty on the other side of the trade.  Nevertheless, perhaps Waldman is correct that investors didn't effectively understand they were making a prop bet verse another party, and thus GS's claim may with respect to this may be false.

4)The most important red herring is GS's claim: "As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa."  Now, that's completely true, but that is NOT what the complaint here is about. The complaint is that Goldman didn't disclose that the seller was instrumental in creating the portfolio itself - not that GS didn't disclose who the seller was.

Interestingly, the pitchbook for the transaction includes many disclaimers, including one that 

"Goldman Sachs may, by virtue of its status as an underwriter, advisor or otherwise, possess or have access to non-publicly available information relating to the Reference Obligations, the Reference Entities and/or other obligations of the Reference Entities and has not undertaken, and does not intend, to disclose, such status or non-public information in connection with the Transaction. Accordingly, this presentation may not contain all information that would be material to the evaluation of the merits and risks of purchasing the Notes."

Now, I am not a lawyer - I don't know if this is the kind of thing you can "disclaim" away (I'd guess not),  although it certainly seems like Goldman tried to. 

So, now that we've talked about what's potentially wrong with GS's defense, I want to focus on my important point:  ACA is not a victim here.  Even if GS was guilty of non-disclosure, I find ACA's claim that they would have behaved differently to be a lame excuse.  As I wrote in my initial response to the suit: "ACA was providing insurance on the portfolio.  It shouldn't matter who they were providing insurance TO, it should matter what they were providing insurance ON."

I think BusinessInsider's Henry Blodget also described the situation very well when he wrote: 

"Presumably, like all investors who have made mistakes, ACA would prefer to believe that it was misled than to accept that its analysts blew it.  ACA, therefore, has a motive to blame Tourre for misleading it.

In reality, however, to make this case, ACA is going to have to make the embarrassing admission that knowing what Paulson & Co was going to do affected its judgment with respect to the transaction.  This information should NOT have affected ACA's security selection process.  It should also not have affected ACA's decision to go forward with the deal.  ACA is an independent firm staffed with experienced professionals paid millions of dollars to evaluate securities by themselves.  What Paulson was or wasn't planning to do, therefore, should have been irrelevant."

This is an essential point.  Note that no one is arguing the merits of GS's disclosure (or lack thereof) here, but I am absolutely arguing that the disclosure shouldn't have mattered IF ACA HAD DONE THEIR JOB. The underlying securities in the synthetic CDO are what they are, regardless of who put them on the list, or who takes the other side of the trade.  They need to be evaluated based on risk metrics, cash flows, etc.  The real issue is that ACA didn't do this work to the level that they needed. 

GS may be guilty of insufficient disclosure - let's just pretend they are.  My point is that even given this failure to disclose, the buyers of the securities in question were grossly negligent in failing to properly assess the values and prospects of the synthetic CDOs, and they are trying to remedy their bad trade by diverting blame.   So hold the Goldman's of the world accountable, but don't let the ACA's of the world off the hook.

I hope to write another post soon about the value of counterparty information in trading markets, how my group used to use it in our trading strategies, and why it fails as a metric in this case. Counterparties definitely matter to traders who might be taking positions on a short term basis, but they should not matter significantly for someone looking for longer term exposure to an asset class which needs to be evaluated based on quantitative risk metrics, like the RMBS synthetic CDOs in question in this case.

-KD

Goldman Sachs's Response to the SEC Suit

I'll leave it to readers to evaluate this on their own, but please do leave it in the comments section if you think this explanation is full of crap and explain why you think that.  To me, it sounds like GS is saying that technically they didn't do anything illegal.  It reminds me of when I was a soccer referee - we learned about the LETTER of the law versus the SPIRIT of the law.  In other words, sometimes the ball bounces up and hits someone in the hands.  By the letter of the law it may be an infraction, but by the spirit of the law it may not be, and doesn't always need to be called.  Or maybe a guy on the other side of the field is in an offsides position but completely uninvolved in the play, so you don't need to blow the whistle.   I think one thing that's emerged widely as a result of the financial crisis is that people have very little tolerance for behavior that violates even the spirit of the law, although it may be technically legal.

here's GS's response:

"Business Wire

NEW YORK -- April 16, 2010

The Goldman Sachs Group, Inc. (NYSE: GS) said today:

We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.

We want to emphasize the following four critical points which were missing from the SEC’s complaint.

  * Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.  

* Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.

  * ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.

  * Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

Background

In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefitted from a decline in the value of the underlying securities.

Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction

IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.

The offering documents for the transaction included every underlying mortgage security. The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.

Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.

The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs’s substantial long  position in the transaction lost money for the firm."

-KD

The SEC Complaint Against Goldman Sachs

Big news today, that the SEC is suing Goldman Sachs for fraud.  The basic gist is that GS failed to disclose relevant information related to the structuring of CDOs it sold.   I'm on the road today, but I have a quick summary.

A friend of mine said to me recently "in thirty years, how will anyone be able to be President?"  He was referring to the ample digital records of everything nowadays, from those naughty pics you post on Facebook, to sarcastic comments you might leave on internet message boards or blog posts, to emails that are archived forever.  Fortunately for regulators, there is more of a paper trail (albeit, digital) now than there was even 10 years ago, which should make their cases more clear cut, and less of a case of "he said, she said."

A reader asked me for some sort of penance for having defended GS in the past, which is a legitimate question.  Now, when I used the phrase "don't hate the playa, hate the game,"  I was referring to legal activities which GS used to get an edge - like having the best technology, or being the most connected in Washington.  You might not like either of those things (and there are many more examples), but they are not illegal, and if you don't like it, you have to change the rules.  I will continue to defend capitalism in capital markets - which results in winners and losers - smarter and less smart - those on the right side of trades, and those on the wrong side.

However, I never have and never would defend the use of illegal methods by anyone - GS or otherwise - and write it off to "tough luck for the losers" or "sold to you, SUCKA."  Obviously, there have to be rules, and now we're seeing them come into play.  If GS consistently plugs their customers with bad deals, the customers should stop trading with them.  If GS is fraudulently misrepresenting its deals, the SEC should step in and prosecute them, which is what's happening.  If GS is frontrunning their clients, I'd LOVE to hear about it, believe me.  (but Daniel, every word I wrote in this prior post is just as true now as it was when I wrote it)

Now, of course, GS will certainly lose the benefit of the doubt (if they ever had any) and will certainly not reap the benefits of any sort of presumed innocence in any future appearance of impropriety.  Everyone's favorite target will perhaps justifiably be presumed GUILTY, and it will be interesting to see if the Powers That Be come down on them hard.  Yahoo's headline on the story mentions that investors lost "$1B" as a result of this fraud.  A billion dollar fine would be relative pocket change for GS.  The real question is what the lasting consequences will be. 

Note on the following quotes:  they are pulled word for word from the complaint, and are in order, but not complete. In other words, I tried to use ellipses (...) to indicate that there were words in between edited out by me)

quotes from the complaint:

"The Commission brings this securities fraud action against Goldman, Sachs & Co. (“GS&Co”) and a GS&Co employee, Fabrice Tourre (“Tourre”), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed 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..."

"GS&Co recognized that market conditions were presenting challenges to the successful marketing of CDO transactions backed by mortgage-related securities. For example, portions of an email in French and English sent by Tourre to a friend on January 23, 2007 stated, in English translation where applicable: “More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!” Similarly, an email on February 11, 2007 to Tourre from the head of the GS&Co structured product correlation trading desk stated in part, “the cdo biz is dead we don’t have a lot of time left.”

The problem gets magnified in the next section, where GS used the illusion of an independent third party manager to assuage potential investor concerns.

"GS&Co and Tourre knew that it would be difficult, if not impossible, to place the liabilities of a synthetic CDO if they disclosed to investors that a short investor, such as Paulson, played a significant role in the collateral selection process. By contrast, they knew that the identification of an experienced and independent third-party collateral manager as having selected the portfolio would facilitate the placement of the CDO liabilities in a market that was beginning to show signs of distress....GS&Co therefore sought a collateral manager to play a role in the transaction proposed by Paulson..."

"In or about January 2007, GS&Co approached ACA and proposed that it serve as the “Portfolio Selection Agent” for a CDO transaction sponsored by Paulson. ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets..."

"Internal GS&Co communications emphasized the advantages from a marketing perspective of having ACA associated with the transaction. For example, an internal email from Tourre dated February 7, 2007, stated: “One thing that we need to make sure ACA understands is that we want their name on this transaction. This is a transaction for which they are acting as portfolio selection agent, this will be important that we can use ACA’s branding to help distribute the bonds...”

"Likewise, an internal GS&Co memorandum to the Goldman Sachs MCC dated March 12, 2007 described the marketing advantages of ACA’s “brand-name” and “credibility”: “We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering.” “We expect that the role of ACA as Portfolio Selection Agent will broaden the investor base for this and future ABACUS offerings.” “We intend to target suitable structured product investors who have previously participated in ACA-managed cashflow CDO transactions or who have previously participated in prior ABACUS transactions.” “We expect to leverage ACA’s credibility and franchise to help distribute this Transaction...”

In short, GS wanted to use ACA's name as a sort of stamp that everything was ok. The complaint then details the back and forth between Paulson and ACA involving the creation of the portfolio, and the returns with the doozy:

"Similarly, a 65-page flip book for ABACUS 2007-AC1 finalized by GS&Co on or about February 26, 2007 represented on its cover page that the reference portfolio of RMBS had been “Selected by ACA Management, LLC.” The flip book included a 28-page overview of ACA describing its business strategy, senior management team, investment philosophy, expertise, track record and credit selection process, together with a 7-page section of biographical information on ACA officers and employees. Investors were assured that the party selecting the portfolio had an “alignment of economic interest” with investors. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio..."

"On or about April 26, 2007, GS&Co finalized a 178-page offering memorandum for ABACUS 2007-AC1. The cover page of the offering memorandum included a description of ACA as “Portfolio Selection Agent.” The Transaction Overview, Summary and Portfolio Selection Agent sections of the memorandum all represented that the reference portfolio of RMBS had been selected by ACA. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio..."

But there was another problem: GS was also playing ACA!  ACA didn't want to sell out and compromise their reputation, so GS led them to believe that Paulson was investing on the long side of the portfolio in the equity tranche!

"GS&Co also misled ACA into believing that Paulson was investing in the equity of ABACUS 2007-AC1 and therefore shared a long interest with CDO investors....Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1."

"On January 12, 2007, Tourre spoke by telephone with ACA about the proposed transaction. Following that conversation, on January 14, 2007, ACA sent an email to the GS&Co sales representative raising questions about the proposed transaction and referring to Paulson’s equity interest. The email, which had the subject line “Call with Fabrice [Tourre] on Friday,” read in pertinent part: “I certainly hope I didn’t come across too antagonistic on the call with Fabrice [Tourre] last week but the structure looks difficult from a debt investor perspective. I can understand Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.”

There is then a discussion of German investor IKB, who would only invest in the CDOs if there was an investment manager like ACA acting impartially to select the portfolio.

"In February, March and April 2007, GS&Co sent IKB copies of the ABACUS 2007-AC1 term sheet, flip book and offering memorandum, all of which represented that the RMBS portfolio had been selected by ACA and omitted any reference to Paulson, its role in selecting the reference portfolio and its adverse economic interests. Those representations and omissions were materially false and misleading because, unbeknownst to IKB, Paulson played a significant role in the collateral selection process and had financial interests in the transaction directly adverse to IKB. Neither GS&Co nor Tourre informed IKB of Paulson’s participation in the collateral selection process and its adverse economic interests."

GS's Tourre again looks to be in up to his neck here, describing the portfolio one way to IKB, and another in internal communications:

"Tourre maintained direct and indirect contact with IKB in an effort to close the deal. This included a March 6, 2007 email to the GS&Co sales representative for IKB representing that, “This is a portfolio selected by ACA . . .” Tourre subsequently described the portfolio in an internal GS&Co email as having been “selected by ACA/Paulson.”

"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 IKB. 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 2007AC1. Among other things, knowledge of Paulson’s role would have seriously undermined IKB’s confidence in the portfolio selection process and led senior IKB personnel to oppose the transaction."

But here's where things get strange.  ACA, the manager, also had a parent company, ACA Capital who provided insurance on these CDOs!!!

"ACA Capital was unaware of Paulson’s short position in the transaction. It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1."

Now I think that is a load of crap.  ACA created the portfolio with Paulson.  They knew EXACTLY what was in it, and for them (or their parent company) to basically use the excuse "but we thought Paulson was long, not short" (not a direct quote at all!) is pretty weak.  ACA was providing insurance on the portfolio - it shouldn't matter who they were providing the insurance to - it should matter what they were providing the insurance on.  The portfolio is the same weather Paulson is a long equity  investor or a short investor.    GS misled ACA as to Paulson's true involvement, but that doesn't change the underlying assets, and is illustrative of the complacency on the part of ACA in effectively evaluating risks.  This is especially confusing, considering that ACA created the portfolio.

This is sure to be a MEGA story, and perhaps indicative of future backlash to come.

EDIT:  GS releases a statement: "The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation"

Wow.  That seems surprising. I mean, it's not surprising that they'd deny it,  but it's surprising that they deride the basis of law and fact involved.  Reading the complaint, you don't have to be a lawyer to conclude that it looks pretty damning. 

-KD

disclosure: short XLF