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Saturday, April 17, 2010

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

22 comments:

Anonymous said...

Hey Kid,

One other aspect to this: ACA was NOT the asset manager but the asset selector. That is the key difference in this deal and most CDOs where the manager has a fiduciary duty to make sure the portfolio performs as best as he or she can within their judgement. In this case, Paulson was co-selector. This was not disclosed. ACA assumed Paulson was helping them select becuase of the long position which never existed.

I am a CDO guy; Goldman is toast here...the next step in the lawsuit mania that is about to follow is to show that there was fraud in the other Abacus cases (Goldman is exposed to 20,000,000,000 of this stuff)...Magnetar and DB's START deals are next

scharfy said...

Good coverage.

They picked off a foreign unsuspecting bank by slipping in a list of overvalued bonds from Paulson under the name of ACA.

From Fab's internal email:

“it is important that we can use ACA’s branding”

They are fucked.

Why Lloyd doesn't pay the fine admit the wrongdoing and end this media bonanza is beyond me.

How are they ever gonna be able to move an IPO at a decent price if investors have to price in Goldman fraud risk into every offering?

Do you think it will play well having a 31 year old kid making 2 mil calling himself Fabulous Fab foisting junk CDO's on German pensions?

They just helped Greece skirt EU regulations with back dated currency swap. Hows that gonna look when Greece defaults?

ACA is to blame as well. And that's why it will hurt business. Because it announces loud and clear that you have to have an army of lawyers, check your wallet, and hide your wife to trade with Goldman in anything remotely complicated. Its send a message we will rape you, not just nickel you.

Goldman, in their own words is "long-term greedy", implying that they want to be the casino and will run a fair roulette wheel.

Do you really want to go to a Casino where you have to check for the 36 numbers and 2 greens every single time you go there?

Again - excellent coverage

scharfy said...

I think this also gives the Volcker Rule a better than 50/50 chance of getting through, which would dismantle/alter much of the banking industry, Goldman the bank holding Co. in the State of New Jersey would be affected.

So as you noted - politics are at play as always.

disclosure: about to short XLF

Kid Dynamite said...

anon @ 1:23pm : thanks for the insights, although it can certainly be debated if Paulson was technically the co-selector, even though they were certainly involved in the process. they key is the "ACA assumed..." that was a fatal flaw for them.

Scharfy: i still haven't figured out if this is going to be the beginning of an all out war on the banks, or window dressing to make it look like the Administration is cracking down on Wall Street, while not really doing anything. sadly, I fear that it leans toward the latter...

as for Lloyd: one route would have been to throw Fab to the wolves and denounce him as a bad apple (someone wrote a post about that this morning, i can't remember who) - but GS doesn't want to do that because they really want to convince everyone that they didn't do anything wrong. it's pretty clear that they can't win that war.

Kid Dynamite said...

oh scharfy, in case it's not clear, i don't agree with the claim "They picked off a foreign unsuspecting bank by slipping in a list of overvalued bonds from Paulson under the name of ACA."

IKB is no victim either - they have the same responsibilities as ACA does to evaluate the assets on their own merit. they failed miserably.

Transor Z said...

KD,

Thoughtful and sensible as always.

If GS really did represent to ACA and/or IKB that Paulson had a long position in line with their interests, that is very bad for GS.

It will be interesting to see how the Paulson-selected assets performed compared to the Paulson de-selected assets.

Whether GS made or lost money on the transaction only goes to their total exposure, IMO. But if they had a net loss I still don't think that will save them from a hefty civil penalty on these facts.

"Due Diligence in a Time of Bubbles" - What is due diligence when the underlying was AAA? I don't think you can charge ACA, IKB and all the other "professional investor" suckers during this period with failure to perform DD when RE was so damned dirty, top to bottom. However, I am very sympathetic to the point Michael Lewis made in his "The End of Wall Street" article that all you had to do was send a team on a plane to physically inspect the underlying to see that something was not adding up.

I think another key point is this: was GS's approach merely transactional or did they go strategically short on MBS? IOW, we know that GS was approaching the Paulson's and the other now-famous shorts to put CDO deals together during this time period, but was GS merely trolling for commissions in volume or something else?

I'm not sure that GS ever extricated themselves from long exposure and just may not have been as smart as everybody wants to believe. Thus the need for the backdoor AIG bailout.

Kid Dynamite said...

good thoughts, TransorZ.

in my opinion, AAA ratings don't excuse the investor from doing due diligence. they are ratings - which is one firm's own due diligence, not guarantees. That might fly for RETAIL investors, but not sophisticated professionals trading products like these.

Blurtman said...

Who wrote the CDS in the Paulson and Magnetar deals?

Please tell me that it was not AIG?

Sam said...

I am very curious to know the answer to Blurtman question above, as I was wondering the EXACT same thing.

Who were the other guys who lost money writing CDS? There were tens of billions in notional on the Abacus deals, not to mention Paulson's and Magnetar's trades. Any thoughts, KD?

JCH said...

From the Greatest Trade one learns that almost nobody believed Paulson in 2006 and early 2007. He could only raise 147 million. GS, initially, went and told him they wanted to bet against him.

So if they, the sophisticated investors, had known Paulson was betting against them, they probably would have ignored "the latest moron to try and short the US housing market."

RJ said...

I completely understand your perspective. It's one shared by many of my friends and co-workers. However, I feel that you are largely missing the point. You label these people as 'sophisticated professionals'… I completely disagree with this description. In what sense to these people deserve to be described as 'sophisticated'. Their qualifications for this label are the following: years of 'experience' in the business with reputable firms, billions of dollars in assets to manage, possession of various acronyms -- MBAs, CFAs, SATs, undoubtedly they are also likable and charming people as well. Notice, that in no way is any demonstrated ability to make competent investment decisions part of the criteria -- what is required is to convince those who may grant you power and pay your salaries that you possess such ability. Those are not even remotely the same thing -- and that distinction in my view is the crucial lesson from this credit crisis. We're all well aware of the oldest profession, but I'm confident that the second oldest profession is the snake-oil salesman. However, I'd take it one step further and submit to you that finance is the perfect storm of an industry with its dependence on volatility and uncertainty in which to breed huge classes of such folks who undoubtedly drink their own medicine -- that doesn't make them any more 'sophisticated', but it does make them more confident and dangerous as we have just witnessed.

To me, that is the salient debate about this crisis. It's not helpful to label various people as stupid… on the one hand I agree… but on the other hand my mother, girlfriend and best friend are all stupid and I wish them well in this world so where does that leave us?

Kid Dynamite said...

good comment RJ, but that's why your mother and your sister cannot buy synthetic CDOs. there are qualifications and restrictions on who can participate in these trades for a reason.

perhaps, as peterpeter mentioned in an earlier thread in response to Daniel, a better solution is prohibit these money managers who are clearly not sophisticated enough from trading these asset classes.

people need to be protected from themselves.

Kid Dynamite said...

blurtman, sam - i dont know who the CDS counterparties were.

Jeff from Miami Limo said...

It makes me sick that these people got away with scaming so many people. I hope they get convictions, and those convictions lead to changes that make sure this type of thing never happens again.

Duff Samoa said...

@KD

Might be wrong but I was under the impression that ACA capital supplied some of the insurance for this particular abacus deal?

hooligan said...

Hi Kid, thought I'd trot back here to get your insight. Coincides with mine.
Paulson handpicked the securities that ACA then stress tested. Bear Sterns owned 38% of ACA didn't it, we should ask which Bear Sterns employees currently employed by JPM are still employed. If this Abacus deal was exceptional then GS can expect to pay a "no admission of guilt" fine of around what $25 billion? $25 million? $2.5 million?

I agree that every player is an adult, caveat emptor must remain intact, but what also must pass is that simply putting in 25 pages of disclaimers does not abrogate fiduciary responsibility, or more importantly to me at any rate, the principal of not cheating to make money.

If a crook sends me a disclaimer through the mail saying he might steal from my house and then he steals something from my house, he/she is still a thief and should go to jail. Similarly, a fence who is included in the disclaimer is still fencing stolen goods taken from my house, so Paulson, ACA or GS may have to answer this point too.
Also, I am not a betting man (well ok I am) but I am also betting that GS took a hit on this deal even after making 15-20 million in fees from both sides, but (along with Paulson) made several hundered million our of buying CDS protection to over off-load it risk, pretty close to immediately afterwards.
I also think that IFK and ABN taking pieces of this deal may have been part of other deals that ABN and IFK (or KFW) may have done with GS that made a lot more money for each of these parties. But then whatis the point on betting on a rce that is over. Who is going to short GS to zero and watch it also get taken over by who, BAC or C or JPM?

hooligan said...

other blogs are saying the counterparty was AIG, but then, this could be vog (volcanic fog).

rootless_e said...

If you really want to see something funny, look that the 2006/7 IKB report which goes on and on about their expensive and sophisticated in house risk management and asset evaluation team

rootless_e said...

JCH: reading the flipchart, you get the sense of GS whispering to IKB about the unnamed counterparty, "we got a live one on our hands, don't spook him, dumbass thinks that ratings agencies don't know anything and that the housing market will collapse, ha ha. "

Daniel said...

I can hardly think of anyone better to comment and decide whether or not an activity was fraudulent than old Pump and Dump Henry Blodget. You really do want to look to someone who has been convicted of fraud and been banned for LIFE from the securities business if you have a fraud complaint to review.

Kid Dynamite said...

yes, Daniel, i'm well aware of Henry's history, but i think the paragraph i c&p'd from him is an excellent summation of the truth.

Sandrew said...

KD,

In response to Blurtman and Sam’s “who wrote the CDS protection” question: Abacus did. That is how synthetic CDOs work. The SPV writes protection to Goldman on the reference assets, in return for which it collects premia that service the issued bonds. Goldman passes off the protection to the Street (from the sounds of the reporting, the lead purchaser was Paulson). To me, the key question here is where did the Equity tranche go? It’s conceivable that they structured the CDS as single-tranche bespoke basket CDS—that is, perhaps the SPV only wrote protection on the 10-100 tranche, which Goldman back-to-backed to Pauslon et al. In this scenario, no one holds the first-loss risk.

Sandrew