ABACUS: A Synthetic, Synthetic CDO

By James Kwak

I actually suspected this, but I haven’t had the time to look at the marketing documents. But thankfully Steve Randy Waldman did. I don’t think I can improve on his description — these things take hundreds of words — but here’s a quick summary.

An ordinary CDO is a new entity that raises money by issuing bonds in tranches, uses the money to buy some other bonds (say, residential mortgage-backed securities) and uses the cash flows from those bonds to pay off its own bonds.

A synthetic CDO is similar except instead of buying the underlying bonds, it sells credit default swap protection on those bonds (the reference portfolio) and uses the premiums from the CDS to pay off its own bonds. (The money it raises by selling those bonds is usually parked in low-risk securities so it is available to pay off the CDS if necessary.)

ABACUS was different. There was a reference portfolio. But instead of selling CDS protection on all of those bonds, Goldman said (to paraphrase), “Imagine we sold CDS protection on all of those bonds. Then imagine we used those CDS premiums to issue bonds in tranches A-1, A-2, B, C, D, and FL. The derivative I’m selling you is one that will behave exactly as if it were an A-1  (or A-2) bond in that scenario — even though we’re not actually selling all of the tranches.”

Does this matter? To think about that, I recommend yet another post by Waldman, in which he takes apart Goldman’s claim that it was brokering a trade between a long side and a short side. Goldman likes to say this because it implies that the long side had to know there was a short side, and hence the failure to disclose Paulson’s role was not material. But that’s not what was going on.

Goldman was creating a new company (a CDO of any variety is a new legal entity) and underwriting bonds issued by that company. In this case, the company’s “business” was writing derivatives that were essentially highly customized credit default swaps (since the swaps mimicked what would have happened had there actually been a synthetic CDO). An underwriter’s role is to induce investors to put their money in the company it is underwriting, which means talking up the qualities of that company while also disclosing its defects; it is not to broker a trade between investors who want the company to do well and other investors who want the company to do badly. And even if the “company” in question is a synthetic synthetic CDO, that doesn’t change.

84 responses to “ABACUS: A Synthetic, Synthetic CDO

  1. Is it James Kwan or James Kwak? A misprint.

  2. What societal purpose is served by the existence of these instruments?

    They sound to me like they ought to be illegal. But then, most of what Goldman does sounds to me like it ought to be illegal.

  3. You need to get some facts straight – or at least clarify your points with more detail. As it stands it sounds as if you don’t know how cash flow or synthetic CDOs are issued and work.

  4. Scot Griffin

    Q: “What societal purpose is served by the existence of these instruments?”

    A: Increasing Wall Street’s short term profits, according to Milton Friedman:

    http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html

    I agree that these kinds of derivatives ought to be outlawed, but how is that going to happen when Friedman’s neoliberal ideology dominates both political parties in the U.S.?

  5. Scot Griffin

    For clarification, read the Steve Randy Waldman post that James referenced in his opening paragraph. James made clear that all he was doing was providing a quick summary of that post.

  6. All those “imagine”‘s are likely to make more than a few heads spin. It’s hard to avoid the conclusion that this seems to have very little to do with channeling available capital to worthy investment projects, hedging uncertainty and spreading risk to those most able and willing and bear it, etc.

    But at the end of the day, GS was only marketing financial instruments that produced different claims on cash payments given different states of nature.

    So long as the buyer is sophisticated and diligent, then the fact that they misjudged the likelihoods of the emergence of the catastrophic states of nature is not relevant to the charges against GS.

    The counter-party investment banks were not misled as to what would happen to their investment should house prices severely decline, or default rates increase catastrophically – they simple believed such an eventuality was highly unlikely. Now they have buyer’s remorse, and who can blame them?

    But they also invested in all kinds of non-synthetic (and non-synthetic-synthetic) securities that also failed miserably, even when they were securitized on a completely random basis and not on the behest of a particular (and almost uniquely prescient) hedge-fun manager. No one is looking for a scape-goat for those bad bets, but that’s just what they all were.

  7. CDO’s like this were called CDO Cubed at the time they were issued. Three years ago, there was a fair amount of exuberant Gummie Bear sweetness written about the CDO Cubed in the financial press. Given that these instruments were sold to creme de la creme professionals, Boobus Americanus type, do these people have a claim about not knowing about the specifics of them? I was required to have a deep understanding of transactions I pushed. Those I dealt with were subject to the same requirement. Is this about lack of disclosure they did not care to inquire about? Usually do gooder commentary accuses everyone claiming professional status investing as being of the ” Should have known” club.

    The purchasers of these should have known better and the pension funds and other fiduciary entities should claw back the salaries of the professionals that bought these CDO’s. ( A joke.)

    If the plodder type pros at the fiduciaries and rating agencies did not know better , just where will the regulators be pulled from? Standard musings I have heard all my life is that government payrollers are the worst of the lot. Shovel leaner’s as my father called them.

    What we really have as a problem is a system of mutually reinforcing mass delusion coupled with intellectual carelessness.

    Besides, the US system is massively Darwinian as any corporate payroller understands. Those captured in the corporate bureacracy understand survival means avoiding the ultimatum from the boss man, ” it’s my way or the highway”.

    The Congress has standing committee’s that should have known enough to propose and discuss legislation given that a financial collapse did occur. That is their purpose. The failure does lead to theatre like two momsers like Levin and Blankfein tangling. Congress is trying to shift the onus on others too. Probably more than any other group.

    While the theatrics continue, the problem gets ever deeper.

  8. Nemo,

    These transactions would have been illegal under most state anti-gambling laws, except that the Banks lobbied to get a special exemption put into the Commodity Futures Modernization Act that pre-empted state law.

    Jennifer Taub went into this in her guest post: http://baselinescenario.com/2010/04/20/clinton-rubin-summers-derivatives/#more-7245

    It is essentially a sports-betting racket, which many people are now figuring out. Some derivatives have a mechanical link to their underlying securities (stock options and bond insurance, for example), which mean that they contribute to the normal part of the financial intermediation that market economies require.

    However, some derivatives (like CDS and synthetic CDOs), have no mechanical link to the underlying securities. They just “move money around”, and work on the same principles as sports betting. They have no “social value” since they don’t actually intermediate between savings and investment.

  9. Which is why I cannot understand why no one is calling BS on the bizniz talking heads who blather about how reining in these abuses will “hurt job creation”. Where? In the bowels of the shadow banks where such creations are wrought? How many of the 8.4 million jobs lost can be laid at the feet of such wonderful financial innovation, I wonder?

  10. Thank you, thank you! The differences between underwriting (primary market rules) and market-making (secondary market rules) are critical. There are much higher duties to clients for the underwriter than for the market-maker. The fact that the “asset” (cash flow claims) being tranched by Abacus was a derivative (of a derivative) doesn’t make the thing sold to the buyer something other than a security subject to underwriting rules, just like any asset-backed security.

    An underwriter always has a “conflict of interest” — between the issuer, who wants the highest price, and the buyer, who wants the lowest. The way the underwriter manages his conflict and meets his duties to both sides is by full disclosure of anything that might be material to the buyer. IMHO, that includes if the underwriter has, for its own account, taken a negative view re the performance of the particular assets or asset class (or the assets which are the reference for the derivative that’s involved).

    In Levin’s terms, if GS thinks the stuff in the ABS is “shitty”, that had better be adequately reflected in the disclosure risk sections and in the pricing. You can’t have one view for yourself and another for your underwriting buy-side clients.

    It’s a whole other matter when GS is a market-maker. GS has no other duty to anyone it plays with — whether acting on its own account or as agent for a client — than to provide best execution — the best price in a timely fashion. Its own “view” on an issuer or asset class — and whether it’s net long or short — is proprietary info. Disclosure would completely undermine its (socially useful) function as a market-maker. [Note, I’m not including the “suitability” requirement for broker-dealers when they’re dealing with retail clients or the much higher fiduciary standard for asset managers. Just the B-D as market-maker or trade executor.]

    I think it’s important that Fab was presented as a “trader”. And that when he defined his duty to clients he gave a trader’s definition. This is a fundamental flaw in how GS has conceived of its business. When Fab was structuring and marketing the Abacus deal, he was acting as an underwriter, not a market-maker. It’s a whole other kettle of fish.

    So with respect to the Senators attacking GS’s shorting activities. It’s more than OK — it’s socially useful — for financial institutions to short a security or asset class, either directly or via derivatives. What’s not OK is to short what you’re peddling as an underwriter to investors, unless all of the reasons why you’ve taken a short for your own account are fully disclosed. Again, in Levin’s terms, if you think the stuff is shitty, you have to say so. And if you’re taking a position in the market opposite to your buy-side investors — which btw could negatively impact the market price of the asset you’re selling to your clients — you have to disclose that as well.

    Now, since it’s unlikely you’ll be very successful at underwriting issues that you have to disclose are shitty and have to show how you’re taking a position that might drive down the price of the investment, the practical outcome is for underwriting firms not to short for their own account the stuff they underwrite. That’s hasn’t been a big problem for equities and bonds. First, the view of a firm’s trading desk on a particular security or issuer will likely be adequately reflected in the disclosure and/or the pricing, since the trading side is going to have to get the deal away, and betting against the deal in their “market-making” function would undermine their ability to place the deal. Or the firm’s investment bankers on the deal side simply won’t take on an issuer that the trading side is shorting (i.e. is driving down the price in the secondary market). And there are also a variety of rules that constrain the market-making operations of underwriting firms in the secondary market before and after a new issue.

    But Abacus (and the Magneto stuff as well) shows it’s a much more difficult management problem for derivatives where there are a host of reasons why the trading desk will be at various times long or short in related assets, which in practical terms may result in the firm’s market-making function working counter to the interests of the firm’s underwriting buyers. Which underscores the rationale for hiving off (or disallowing) prop trading of derivatives from firms that do underwriting.

  11. While the circus continues in the senate hearings, it’s apparent to me that the REAL regulations that were dismissed in the 80’s & 90’s aren’t coming back. (does anyone remember the S&L scam, the banks all kept the money including Bush.) No new regulations can change another administration’s ability to “UNDO” said regulations. We need laws on the books ie., making gambling as a way of doing business illigel for banks, investment banks etc. GS duped some clients & they know it. Everyone is expendible where money’s concerned. The memos from employees on the inside of GS should say enough. They knew these deals didn’t pass the smell test, but still went along with it. Everyone who makes money doing this will not stop until it’s against the law!

  12. “An underwriter’s role is to induce investors to put their money in the company it is underwriting, which means talking up the qualities of that company while also disclosing its defects; it is not to broker a trade between investors who want the company to do well and other investors who want the company to do badly. And even if the “company” in question is a synthetic synthetic CDO, that doesn’t change.”

    That’s not right.

    First, the underwriter works for the issuer. The underwriter does NOT work for the purchaser. So the buyers of the securities CANNOT have thought that GS had a duty to them beyond GS’ duty as an underwriter not to make a materially misleading statement in the prospectus. Saying that GS’ duty was to the purchasers because GS was acting as an underwriter inverts the operation of the securities laws.

    Second, the buyers knew that the issuer was a special purpose entity being formed for the transaction that was not actually purchasing any RMBS’s. Therefore the buyers knew that SOMEBODY was on the other side of the trade. There are only three possible somebodies: 1) GS. 2) A single GS client. 3) Multiple GS clients with derivatives matching the flipside of the risk.

    So whatever “conflict of interest” there was cannot have been a HIDDEN conflict. The buyers knew that either GS or one or more GS clients was on the other side of a zero-sum trade.

    Third, the statement “it is not to broker a trade between investors who want the company to do well and other investors who want the company to do badly” is misleading. The sale of a newly issued security always transfers risk from the seller to the buyer. In an vanilla IPO (simplified slightly), the sellers are giving up a degree of “wanting the company to do well.” That is what they are selling. It is true that, ordinarily, one expects that the sellers will retain some other interest that makes them continue to want the company to “do well,” but that isn’t necessarily the case.

    An uncontroversial example would be if the sale of a company by an owner is structured as a new issuance of securities. The seller cares not at all how the company does post-transaction.

    Fourth, that leads to the final point, which is that the argument made in today’s Times Online, that synthetic CDOs have no social utility because they are zero-sum and therefore do not allocate capital, and are too illiquid to create price visibility, seems very persuasive, but I don’t think its right. The answer to it, I think, is synthetic CDOs are a way to short the subprime mortgage market. They made more “CDO-like risks” available on the market, thereby reducing the price charged for CDO-like risks, thereby reducing the demand for subprime loans to purchase. Put another way, an instrument can perform a socially useful price discovery function even though the “price” that is “discovered” isn’t the price of the instrument itself.

    What am I missing?

  13. I would like to see Johnson/Kwak to engage Jenkins of the WSJ. Where do you agree/disagree?

  14. These transactions would have been illegal under most state anti-gambling laws….

    Bring back the bucket laws! That’s part of the necessary measure, ban all speculative derivatives. Send them back to the grimy alleys where they belong, and let these effete banksters try to enforce their “contracts” there. (That’s part of why I don’t get all the sound and fury about cross-border regulation of these things. Just de-legalize these things as contracts, and the job is done.)

    In “The Godfather” Tom says “Right now we have the numbers, but narcotics is the wave of the future.”

    Man, did he underestimate the numbers racket, once that branch of organized crime was completely legalized and moved to Wall St.

    James’ post above was the latest of god knows how many descriptions of these things I’ve read, and it’s still unanimous: Not one of them throws the slightest glimmer of light on the question, What is the constructive purpose of this gambling? Why should it be allowed to legally exist at all?

    Of course there is no legitimate answer, only risible lies.

  15. @Amos You said: “First, the underwriter works for the issuer. The underwriter does NOT work for the purchaser. So the buyers of the securities CANNOT have thought that GS had a duty to them beyond GS’ duty as an underwriter not to make a materially misleading statement in the prospectus. Saying that GS’ duty was to the purchasers because GS was acting as an underwriter inverts the operation of the securities laws.”

    Not exactly. In a securities offering, true, the underwriter’s “client” is the issuer, but the underwriter owes far more duties to the buyers than is the case in the secondary market (primarily due diligence and disclosure of any material info, but also not to manipulate the price before the offering or trade against the buyers in the immediate after-market). Whereas a broker-dealer who is making a market is only obligated to meet execution standards, even when acting for a client. Fab wasn’t a trader, he was an underwriter and therefore has a different standard of care owed to the buy-side.

    Setting the whole Paulson matter to one side, what Levin is saying is that, if you’re the underwriter and you think the deal sucks, either don’t peddle it or make sure that the disclosure is clear how sucky the deal is. And if you’re taking a bet on your own account against the deal (or against the asset class as a whole), shouldn’t that be included in material information for the buyer?

    Amos also said: “The sale of a newly issued security always transfers risk from the seller to the buyer. In an vanilla IPO (simplified slightly), the sellers are giving up a degree of “wanting the company to do well.” That is what they are selling. It is true that, ordinarily, one expects that the sellers will retain some other interest that makes them continue to want the company to “do well,” but that isn’t necessarily the case.

    An uncontroversial example would be if the sale of a company by an owner is structured as a new issuance of securities. The seller cares not at all how the company does post-transaction.”

    Actually, in your plain vanilla equity deal, the degree to which the sellers do or don’t retain an interest in the company, and if they do, the conditions under which they can unload all or part of their interest, is extremely relevant to buyers in a primary offering. Not just due to a possible overhang of shares retained by the seller (and underwriter), but for understanding the sellers’ incentives both at the time of the issue and, if they hang on to an interest, going forward in order to assess whether the buyers and sellers’ incentives are aligned or potentially in conflict. Lock-ups and clawbacks are big parts of what underwriters negotiate with (against) their client issuers. In effect, the underwriter is negotiating on behalf of potential buyers who will discount the price or not buy the deal if their expectations re the sellers’ incentives aren’t met. Just as with final pricing of a deal, it’s another example of the underwriter’s natural “conflict of interest” — the “client” is the issuer, but the underwriter is effectively sitting in the place of (at least the minimum necessary to satisfy) the buy-side in structuring the deal.

    So it seems to me that whenever risk is being transferred, it’s always “material info” as to who is shifting the risk, how and why.

  16. Oh,how the old mob bosses must br frothing at the mouth. The Bankster’s (mobster’s) have stolen the age-old scheme of the “Vig”,and have up-the-ante. How simple,and beautifully twisted does it get? You buy off the local cops (SEC/Rater’s)and let the games begin. I myself loved my “Number’s” – clean,and tax free {just like today GS’s profits with the house’s (AIG/TARP?),bankroll}and when my bet was large – my man just called around (AIG/JPMC&ML/GS/Citi,..etc.),and the money makers took the other side,how sweet it was) to cover the other end. But,the Gov’t has a hard time figuring out such a very complicated transaction the “VIG” be? Whoa is me.

  17. CBS from the West

    This is one of the clearest discussions of the fine points of this kind of deal that I have seen, and I thank nadezhda for posting it.

    But I think all of this misses the point. On a simple moral and ethical level, selling somebody (and it doesn’t matter who or what your relationship to them is) an item you know or rationally believe to be defective without telling them as much is simply wrong. To follow that up with a side-bet with others that item will fail is just unconscionable.

    The business model underlying this kind of transaction is nothing more than parting fools from their money. As long as that remains a dominant business model (in finance and, for that matter, many other sectors) our future will be dismal.

    The fact that we are even discussing the legality or commonality of this kind of transaction says that our laws are a joke, our business ethics a travesty, and our society nothing but a kleptocracy.

  18. “An underwriter’s role …” This is where you depart from facts and enter the realm of unsubstantiated opinion. Just because you assert the they were underwriter and that that role is inconsistent with GS’s actual conduct, does not make that factual.

    What is your citation for that allegation?

  19. Where did I say that the underwriter works for the purchaser?

  20. @nadezhda – Clearly you have a basic understanding of the operation of the financial markets. Very basic. Are you a law student, a junior law firm associate, or some sort of finance student?

    You say: “In a securities offering, true, the underwriter’s ‘client’ is the issuer, but the underwriter owes far more duties to the buyers than is the case in the secondary market . . . [including] not to manipulate the price before the offering or trade against the buyers in the immediate after-market)”

    Then you say: “Whereas a broker-dealer who is making a market is only obligated to meet execution standards, even when acting for a client. Fab wasn’t a trader, he was an underwriter and therefore has a different standard of care owed to the buy-side.”

    You’re confusing duties, regulations, and standards of care. The underwriter’s duty is to the issuer and it is contractual. The underwriter also acts to purchasers as a guarantor that the issuer did not commit fraud, by assuming limited liability for materially false statements -in-the-prospectus-. That liability can be avoided by demonstrating due diligence. The underwriter, like anyone else, is also barred from committing securities fraud through market manipulation. And there are also specific regulatory bars in trading around IPOs by underwriters, which are meant to curb particular public market abuses. The underwriter does not owe a duty of “total fairness.”

    You say: “what Levin is saying is that, if you’re the underwriter and you think the deal sucks, either don’t peddle it or make sure that the disclosure is clear how sucky the deal is.”

    That’s fine in hindsight. Do you remember 2007 and 2008? I do. There was a very real possibility that the government was going to bail the borrowers out. If that had happened, the lowest CDO tranches might have been properly upgraded to AAA and identify of the winners and losers would have been very different.

    Calling this, or any zero-sum instrument, a “deal designed to fail,” or a “sucky” deal, is just weasel-words. A zero-sum instrument necessarily creates a winner and a loser. Which would be which was hardly a certainty in 2007.

    Actually, your argument is even less coherent than that. Is GEICO required, in its ads or on its policies, to include a disclaimer that its more likely there won’t be an accident so the policyholder will probably lose money on the deal?

    These are hedging instruments designed to allow sophisticated investors to include particular risks in their portfolios.

    You say: “if you’re taking a bet on your own account against the deal (or against the asset class as a whole), shouldn’t that be included in material information for the buyer?”

    It always is. There’s no allegation that GS failed to do that, or that banks who packaged CDOs failed to do that generally.

    You say: “the degree to which the sellers do or don’t retain an interest in the company, and if they do, the conditions under which they can unload all or part of their interest, is extremely relevant to buyers in a primary offering. ”

    There is no allegation here that GS lied about the extent to which it was retaining, or not retaining, an interest in the instrument. Nor is that, generally, an allegation made against CDO promoters.

    You say: “the underwriter is negotiating on behalf of potential buyers who will discount the price or not buy the deal if their expectations re the sellers’ incentives aren’t met. Just as with final pricing of a deal, it’s another example of the underwriter’s natural ‘conflict of interest'”

    1. Wrong. The underwriter in your example is acting in its capacity as investment banker, advising the issuer on how to structure a transaction to obtain capital at a desired price on the capital markets.

    2. “Conflict of interest” is not a dirty word. Everyone in business has a “conflict of interest” to the extent they negotiate with their customers, and purchase goods or services from vendors which they they sell (perhaps repackaged). There is nothing wrong with that.

    “Conflicts of interest” are inappropriate to the extent (a) the person with the conflict has a specific duty to NOT have a conflict, and (b) the conflict is hidden. In the case of investment banks, with very limited exceptions they do not have the duties described in (a), and they invariably avoid (b) by disclosing the existence of potential conflicts in every e-mail, prospectus, and publication.

    3. You’ve missed entirely the fundamental point of my post, which is that synthetic CDOs and other zero-sum instruments do, in fact, perform a socially useful price-discovery function.

  21. Note that as I read the offering document it said that pension funds under ERISA could not invest. It looks like it was dumb german banks that invested. The securities also were banned in a number of countries due to registation requirements (singapore etc.)

  22. Re: @ Mr. James Kwak,…Your a wonderful journalist,investigative reporter,and absolutely fantastic author. Thanks Mr. Earle,and please,…keep up the “Good Digging for America’s Sake” :^)

  23. @nadezhda – I misunderstood slightly where you said “And if you’re taking a bet on your own account against the deal (or against the asset class as a whole), shouldn’t that be included in material information for the buyer?” to not include your point about asset classes.

    Reading you correctly, I think what you mean is that GS should have disclosed to Abacus purchasers if, at the time of the transaction, GS as a whole was net-long or net-short the housing market.

    That point is wrong in numerous respects, some of which I will enumerate:

    1. Actually, there is supposed to be a Chinese wall between the banks’ investments on their own account (their “buy sides”) and their investment banking activities (“sell side”). That Chinese wall was the product of the financial scandals of 2000 and 2001.

    2. If the information were disclosed as you describe, you would be creating an opportunity for massive front-running.

    3. The categories of disclosure only make sense in hindsight. In 2007, should GS have disclosed that it was net-short housing? Net short RMBS’s of 2006 vintage? Net short A-2 CDO tranches based on 2006 vintage RMBS’s? Must GS disclose its entire buy-side portfolio with every sell-side transaction?

    4. Following on (3), if complete disclosure is impossible or useless, then it would seem equally sufficient for the bank to interpose a Chinese wall between the buy-sides and sell-sides, while telling investors that the firm may take directional bets. But, doing that is your complaint addressed in (1) above.

    The bottom line is that you seem to want to force a separation of buy-side and sell-side banking activities. Whether that’s a good idea or not, its difficult to see how -not- doing that could have had anything to do with the financial crisis.

  24. Options are derivative securities based on publicly traded stocks; index options are derivatives based on a published indexes of stocks, (DJ, NASDAQ, etc.), but you would never be asked to deliver a ‘basket’ of stocks if your option was called. In this way, index options are ‘synthetic’. Their artificial nature allows stock investors to hedge (insure) their portfolios in advancing or declining markets.

    I think that the history of how this once fragmented market was pulled together by the Chicago Board of Trade provides a ‘best practices’ guide of how traders, regulators, and bankers can work together to legitimize, capitalize, and grow a nascent derivatives market.

    Securities options appeared just as obscure and irrelevant to the general public in 1973 (opening of CBOE), as CDO’s and their synthetics do today.

    And don’t tell me that you can’t ‘standardize’ a contract to make a CDO/swap market.

    I guess moguls at Goldman and the others thought that they were bigger than the market they were pushing.

  25. The essence of the argument you are making is that GS breached a duty that it owed to securities purchasers, which duty existed because GS was acting as in its capacity as an underwriter rather than a different capacity as “market maker.” (Which is not the same as “making a market,” what GS says it was doing, anyway.) Waldman is even more explicit about this.

    I think my comment quoted from the relevant portions of your post before addressing them, to identify clearly what I was referring to.

    In all events, I hope you respond to the price-discovery point. I think your argument is wrong, but not trivially wrong, and its by far the most interesting aspect of the debate. (This stuff about underwriter duties is rather trivial, and I have little doubt will get filtered out pretty quickly in the SEC’s lawsuit.)

  26. Somehow a creepy feeling from these mounting allegations is adding to the ‘layers’ of reasons behind Henry Paulson’s appointment to Treasury.

    Now the list contains ‘immunity from prosecution’ as a 4th or 5th explanation.

    As long as we sit motionless and trust in our representatives (James Ensign…really) the BEAT GOES ON.

    Are we to believe that we haven’t been set-up?

  27. I think perhaps you’re not considering that the market itself is not transparent, therefore how did these products in any way affect my knowledge of the market or the price point? It is concealed by design. Therefore, it losses its social utility. I’m a huge supported of short sales for the purpose you speak of above. But, I don’t see it here, at all. This created a pipeline for bad mortgages and then synthetics used the selected ones, grabbed investors pulled them in a backroom with a small oligopoly of players. Not a liquid short market like an exchange. What am I not seeing?

  28. @Markovich — No, I am considering that. Not all markets have tickers. When I go to Duane Reade and buy a soda, neither I nor Duane Reade issue a press release about the deal but we are still transacting on a market and the transaction is part of the totality of information that determines the price of soda.

    By purchasing Abacus tranches, demand for that sort of risk was being satisfied. Even if you did not see the transaction, someone else who wanted to sell CDO risks had to offer a better price because, the Abacus purchaser’s demand having been satisfied, there was one fewer buyer on the market.

    This is true whether the market is “transparent” or not, and whether it is “efficient” or not. It is true simply because there is, in fact, a market.

    Notably, many of the Abacus tranches did not price — demand by that time had been saturated.

  29. Re: @ jhanlon____The underwriter’s role is the (the mob’s bookmaker that figures the spread, that being the over/under,or points – they’ve got some smart savants crunching the numbers,and probability ratio’s)financial (GS’s)house. The Hedge (Paulson & Co.) Fund (gets to the baseball pitcher,football quarterback,hockey goalie,basketball foward,horse race jockey,and on, and on too make the bet solid with the “Fix”) proposes a structured product, and fowards {which he bribes the underwriter with a small fortune (point shaving)}the package,asking the underwriter (GS’s) too leave out certain specifics, and between the two,they hoodwink the third party (the average joe making the bet) into buying into the ruse. Both sides (consumer loses) win. PS. This is where the big money is made (its done completely in the head with both sides having only a silent verbal commitment.) Amazing,…and as stupid as it sounds,stupid never gets caught holding the bag?

  30. Eureka, I think I may have an answer generally acceptable, quick and easy. Could this be true?

    Answer is:
    1: We need a statement that defines the attributes of an acceptable derivative.

    2: Derivatives MAY be presented by traders for approval as fitting within the attributes and will honor recourse as defined. We could expect levels of recourse (1-n) to reflect level of recourse?.

    3: Good housekeeping tick of approval to be an SEC(?) responsibility.

    4: Investors may require derivatives with this approval or may (caveat emptor) elect to buy unticked derivatives.

    5: Derivatives that are ticked have constant recourse level attached. No evasions a la GS tricks!

    Ergo – Market is free as a bird but has safety available. All philosophies (crooks, fools, others) may do as they will. Politicians are not required to be King Solomon! Fed could probably implement this in 30 days. Foreign banks may seek the tick or not as they decide.

    Not being a banker or lawyer I am sure the idea needs working over.

    Any comments.

  31. (I have added to my earlier post so have posted again)

    Eureka, I think I may have an answer for thje problem of managing the derivative market (risk hazard) that is generally accept)able, quick and easy. Could this be true?

    Answer is:
    1: We need a statement that defines the attributes of an acceptable derivative.

    2: Derivatives MAY be presented by traders for approval as fitting within the attributes and will honor recourse as defined. We could expect levels of recourse (1-n) to reflect level of recourse and parallel risk profiles. Rating agencies would find the better risk focus much easier to evaluate and investors could be clear re the level of risk they are prepared to buy?

    3: Good housekeeping tick of approval to be an SEC(?) responsibility. This service to be fee-paying.

    4: Investors may require derivatives with this approval or may (caveat emptor) elect to buy unticked derivatives.

    5: Derivatives that are ticked have constant legal recourse level attached and traders my be required to make contingent provision for liabilities. No evasions/tricks or non-disclosures as an out!

    Ergo – Market is free as a bird but has safety available. All philosophies (crooks, fools, others) may do as they will. Politicians are not required to be King Solomon! Fed could probably implement this in 30 days. Foreign banks may seek the tick or not as they decide. Foreign traders may be required to place provision funds in a suspense account in a US bank with Fed signature also required for withdrawal?

    Not being a banker or lawyer I am sure the idea needs working over.

    Any comments?

  32. @Sandi… Curtailment of structured finance will reduce the employment prospects of the “tick class” that feed off the belly of the real economy. Without all of these enormous “make work” deals, many lawyers, accounts, broker/dealers, traders, client executives, etc. would be out of business. As I have suggested elsewhere in comments, the real drag of this employment is to sideline what could be productive capital on the sideline in the swirling cathedral of the capitalist casino, which has less and less interest in real investment and more and more interest in economically harmful, fee-based debt churn.

  33. Great comment!

  34. Exactly.

    AND….

    Why is Timmy-the-tax-cheat still Secretary of the Treasury?

  35. Nonsense unworthy of this forum

  36. The people constructing the CDOs get paid. The brokers get a commission for selling the short side and selling the long side. The ratings agencies get paid (very well) for not peeking under the covers and rating this stuff AAA. The institutional investor gets paid to manage your IRA or 401(k). How many of the 8.4 million jobs? Maybe a couple.

  37. Well, then they shouldn’t be allowed to take that risk with other people’s money, primarily. (mostly on leverage too to meet/beat earning cycle) and secondly, because of what happened, the market needs to be visible. I don’t even trust the PEOPLE at the banks enough to give a unit the power to do what it did to AIG. It incentives bad behavior. Too big of a societal risk to meet this demand you speak of. If a single person wanted to make a naked bet with another single person, with only their own money, I’ll let you talk me into that. Otherwise, I think the technical is over ruling the basic common sense that most of this is not their own money. Accredited investors is legal speak most of the time for OPM.

  38. I have a great deal of trouble with the fiduciary standard, or standard of acting in the “client’s [read purchaser’s] best interest” in the underwriting function. For example, exactly what is the “best interest” of a purchaser who is short the housing market (by whatever means) and comes looking to add long exposure (by whatever means) in order to hedge the risk? If the banker believes very strongly that the housing market is about to collapse, does he honor the purchaser’s desire to obtain a more neutral position, or, must he refuse to deal with the purchaser because of his own view of the market?

  39. @CBS from the West… If you follow Blankfein’s “risk exposure” argument, you might ask, “Why would anybody want indirect (these were synthetic securities) risk exposure to assets that are almost certain to fail?” In William K. Black’s, “The Best Way to Rob a Bank Is to Own One,” he describes high-flying control frauds that use daisy-chained investments to set up mutually beneficial toxic asset purchases. In such a scenario, the frauds agree to buy each others toxic assets at profits for both parties. In these, “I’ll buy your dead cow if you buy my dead cow” transactions, the net economic effect is to show through profit-generation that otherwise fraudulent deals are legitimate. According to Black, the frauds use the time bought from these maneuvers to buy additional time to engage in… fraud.

  40. @markovich – I think you are confusing yourself with the pronouns.

    The “other peoples money” invested by GS would be the GS shareholders’ money. The complaint here is that GS engaged in transactions (shorting the housing market) that were highly profitable for those shareholders, and saved the taxpayers money for not having to bail out GS.

    Perhaps the “they” you want to complain about is the now-defunct purchaser, ACA.

    I think its actually rather ridiculous that ACA is being portrayed as some sort of innocent securities investor. ACA was a bond insurer. Selling insurance on bonds, which is exactly the economic substance of what Paulson & Co. got from ACA in this transaction, was ACA’s business.

    Not that any of this had anything at all to do with AIG.

  41. Amos: You said he had a basic understanding of the finance markets, very basic. Personally, I think you have over intellectualized the whole thing to the point of overlooking massive bailouts and losses of trillions of dollars in cash and productivity.

    Diligent people like you can attempt to rationalize anything, even using logic. The Senate could hardly get around the fact that GS was a market maker and a participant. I found that humorous, as if, where has everyone been? But, you’re not discussing something. The financial disasters from LTCM through today putting forward arguments like yours to risk (gamble) other people’s money end in failure. The failures are getting worse because the leverage is higher, the participants are less, and the interconnections are more intense. I’ll bypass the Federal Reserve and taxpayer role, because that’s obvious. The banks at stake now are even more TBTF than they were in 2008. I’m not taking political promises from anyone. That’s a true naked bet.

    Obviously, the biggest players in the industry, once they were holding other people’s money, we’re far less sophisticated than the author to your reply, whom you said the same. Are you going to grant licenses to bet other people’s money to be sure Amro’s next buyer knows more than to fall for a sales pitch when awash in other people’s money?

    I still believe that shorting is essential to the market and doesn’t apply here.

  42. @markovich –
    I take the non-replies from both Kwak and Nadezhda (who I assumed was female, actually) to be concessions on their part.

    I don’t think there’s much to say in response to your argument, except to point out that your current position — when some people manage others’ money it “ends in failure” — is not an argument against derivatives. It is an argument against both (a) professional investment managers, and (b) the existence of corporations, which separate management from ownership.

  43. I’m not buying it. These are material omissions to their client. It was engineered as such, to fail AND to omit information from one side and not the other. It’s not even balanced, if it were perhaps engineered the other way. You started by rationalizing legal duties. I thought you were wrong on that point (which will be proven soon), wrong on social utility (already proven), and added an incentive discussion by noting this is everyone else’s money. Depositor banks, pension funds, etc., were involved in GS’s products. I also think that GS wasn’t risking only their own shareholders money and I bet I could prove even more knowledge of systematic risk and more if I had better access to GS.

    Bottom line, I read plenty of elegant arguments everyday, just as I saw the same for 10 years reading prospectuses on products like Abacus. It always sounds great until you apply people and common sense. The perverse incentives are obvious when you back up. We didn’t build this country on all this fantasy need for a perfect hedge which just ends up being a nonproductive bet. At this point, banking is arguing itself into being regulated as a utility. It needs be saved from itself.

  44. Re: @ jhanlon____I’m sorry,that I’m not worthy kind sir.:-(

  45. Amos, if I can make the rules of a game, I can guarantee that the outcome, however immoral it may be, is legal.

    All you are doing above is explaining how GS will be able to argue that didn’t break any rules. But the “fix” was in long before Abacus or any particular CDO, squared or otherwise, was created. The “fix” wasn’t Paulson’s involvement, but the meeting with Christopher Cox to ensure that such bets were neither insurance nor gambling. Once that was agreed, GS and other sophisticated players knew exactly how to structure their bets to further their interests.

    As to your main point — that such structured financing provides a useful function of price discovery — you completely ignore any cost/benefit analysis. I believe the burden is on those who innovate to prove that the benefits are worth the cost. Given the past two years and what is continuing in Europe today, you and other apologists for these innovations cannot possibly meet that burden. Indeed, I have yet to see anybody even try.

  46. I agree with your standardization comment. This gets in the way of their profit, which is hiding prices. Bigger bonuses too.

    I have seen and heard too many of the ‘smartest’ bankers in history, as lauded, apologize for all these unintended consequences of their previous technical and ‘obviously logical’ arguments. I’ll agree with one thing GS said yesterday regarding ‘getting back to home’ in 2007 even though they ended up betting big the other way. Yes. This country needs to get back to home, the basics. If we lose some ‘growth’ or transaction because of that, so be it. The truth is, in a free market, we’d have killed the inefficiencies and all the people associated with it would be gone over the last two years. Instead we propped them up, artificially. No fresh soil. The market should have crashed out the hot air for an extended enough time to build a realistic base. It didn’t. Bankers (and .gov) stopped believing in the other side of the market too, which is essential.

    We violated market principals to prop up asset values. Now, the bankers are coming out to assert the same arguments. If their previous soft money idol, Alan Greenspan’s model was wrong, they could be just as wrong and just as convicted.

    Every banker should be forced to disclaim until 2015, “We were catastrophically wrong last time with equally sophisticated arguments, but let me suggest anyway…”

  47. This comment should be enshrined as the ultimate example of a financial insider’s self-justification. It’s all trees and no forest. So, your nice little economy nearly collapsed? Sorry proles, stuff happens. But,don’t worry all you junior law firm associates, we masters of the universe have it all under control and besides, you’re all to stupid to see through the oh-so-complex smokescreens we’ve thrown up to hide the fact that what we do subtracts value from the universe. Sometimes all the explaining in the world doesn’t equal one bit of justification.

  48. Anonymous: Are we possibly making things too complex?
    If a broker (underwriter or dealer) knows that the deal being sold is biassed to fail and this is not being made known to the client then the broker should go straight to the slammer! This is a straight con job! The deal which is the basis for the SEC case against Goldman Sachs looks like a situation where Goldman Sachs knew the counterparty had selected the mortgages. These had been filtered by ACA but were still loaded dice. GS concealed a significant fact from their purchasing client. Whether GS later made a trading profit or loss is immaterial.

    It appears that GS concealed this information to ensure a s****y deal could be sold! No way this can be dressed up to look like Goldman Sachs was looking after their client? Remember the ‘wolf in sheep’s clothing’? Mr.Blankfein was reported as stating that Goldman Sachs was there to make profits and client’s were of secondary if any concern? Pretty clear?

  49. @Jeffrey –

    The “rules” of this game are the Securities Act of 1933 and the Exchange Act of 1934. And the flaw in the claims against GS aren’t technical, they are fundamental: GS was not acting on behalf of ACA to create a security for ACA to invest in. ACA was a bond insurer that GS solicited to provide insurance for bonds so that someone else, who ACA was aware of (if not by name) could take the other side of the transaction.

    The law, in this transaction, properly aligned the parties’ duties with their economic roles. Put another way, the transaction was well-designed and bona fide.

    As to your secondary point – you that “the burden is on those who innovate to prove that the benefits are worth the cost.”

    Free societies, however, are defined by the presence of “negative rights.” That is, we can do something in the absence of a rule forbidding us from doing so. We do not need to ask the government’s permission before acting.

    As many of the other commentators here, your argument seems to be a simple, eloquent aphorism, the sort of “common sense” idea we can all get behind. But it isn’t. Like Markovich’s argument turned out to be an attack on the existence of the corporation, your argument turns out to be an attack on the idea of freedom itself. And yes, I do mean it.

  50. @jrw – Assuming that you were directing that at me, thanks! Never been enshrined before.

    There’s no reason to associate the abacus transaction with any serious harm in the financial crisis anyway. The losers in the trade were (1) a marginal bond insurer whose business was “managing” CDOs, (2) the German bank that hired the marginal bond insurer, and (3) a Dutch insurer that was later acquired by the Royal Bank of Scotland.

    Net-net, money was transferred from a group of not-so-quick financial managers in Holland, and the shareholders that hired them, to a group of brighter financial managers New York, and the investors who hired -them-.

    I think you can put down the torches and pitchforks.

  51. carping demon

    @Amos: I think what you were missing @ 2:55, was some kind of forthright exposition of why, “Net-net, money was transferred from a group of not-so-quick financial managers in Holland, and the shareholders that hired them, to a group of brighter financial managers New York, and the investors who hired -them-” makes a damned bit of difference in the real economy.

  52. Attacking the nonsense world of synthetic CDOs is an attack on freedom itself? What a blowhard. Is that too torches and pitchforks for you?

  53. Re: your point that the “buyers know there is someone else on the other side of that trade” Here is what you are missing…

    We agree that the bonds of a vanilla CDO (an entity owning the RMBS) is a security covered by the normal requirements of prospectus, full disclosure etc.

    If a CDO squared or cubed (an entity designed to perfectly mimic the cash flows and risk profile of a vanilla CDO) issues bonds, why shouldn’t those securities also be covered by the normal requirements of prospectus, full disclosure, etc.?

    Goldman Sachs crossed the line. They convinced themselves that the bonds of an entity whose business plan was to make money from derivatives were in fact a zero-sum derivative. They weren’t derivatives. They were AAA bonds of a legal entity that had some business model judged strong enough for an AAA rating. And that is the heart of the fraud right there.

  54. Plebeianswillrevolt

    Russ, that was a great post. What will it take? Armegeddon, a Catageory 9 catastrophy similar to the one that is bubbling up from the ocean floor south of New Orleans. Watch how that changes things, wait till the next financial meltdown without a government bail out.

  55. Their slander of freedom, their dragging it through the mud of their own criminal cesspool, is on the ledger of their crimes.

  56. Hillbilly Darrell

    And don’t forget, should you inadvertantly acquire an inordinate number of dead cows on your balance sheet you can enter into a handy dandy Repo-105 or other iteration of a Repo “sale” at the 11th hour as you cram to fabricate your 10K or 10Q. Staggering out our various fiscal years helps in this effort, from a logistics perspective. I would much appreciate it if you’d reciprocate and “buy” the inordinate amount of dead goats I possess on my balance sheet…..

    Oh wait, we only needed Repo when we were constrained by those pesky MARK TO MARKET rules……which were are no longer hamstrung by.

    Thus, you keep your dead cows and I’ll keep my dead goats, until maturity. And, until “maturity” said “cows” and “goats” will be fully reflected as live….

  57. @ Amos. You said: “3. You’ve missed entirely the fundamental point of my post, which is that synthetic CDOs and other zero-sum instruments do, in fact, perform a socially useful price-discovery function.”

    I wasn’t arguing with the theoretical social utility of derivatives for price discovery. In fact, you will note that I stated explicitly that there’s no question that derivatives can and often do play that useful function. In theory, the positions taken by GS, Paulson and others who made out well by shorting real estate assets ought to have limited the amplitude and duration of the bubble. It’s difficult to demonstrate that happened, however, and there’s also some evidence to suggest that the counter in fact occurred. So it’s not clear that we should be willing to pay a high price in terms of either financial system instability or massive losses by investors in order to obtain whatever benefits of price discovery were produced by the explosion of structured CDS-related deals. And experience has demonstrated that relying on the “sophistication” of the participants isn’t, for the system as a whole, a particularly satisfactory risk management tool.

    As for the specific sorts of deals like Abacus, I think these private exotic bespoke deals didn’t contribute much at all to improved price discovery in the broader OTC markets. They were private precisely because folks like Paulson couldn’t get an acceptable price for the quantities they were looking for if their full appetite for shorts was exposed to the market. It appears that the lion’s share of the CDS-related stuff created from 2005 onwards just inflated the amount of dodgy assets that were available to fuel the crash. There may have been (modest) price-discovery benefits from these deals, but given how much they amplified leverage, the system overall would have been much healthier if, in the aggregate, most of them had never been done. Of course, folks like GS couldn’t have created so many dodgy assets without the rating agencies and the idiotic insurers. So I’m in no way suggesting that if we just made investment banks like GS “virtuous” our problems would be solved.

    However, my response wasn’t aimed at a discussion of the social benefits of price discovery or how to prevent all future bubbles and crashes, but rather at what the Senate hearings suggest we ought to be thinking about regarding the responsibilities of financial intermediaries based on the experiences of the past few years. It seems to me that we’ve witnessed a serious dilution of the level of responsibility we expect the intermediary will undertake with regard to the quality of the transactions or assets they bring to market. This may not have been a matter of a dilution of legal standards — GS and others may indeed not have any legal liability for the drek they structured or sold, even when they thought they were pushing “shitty” deals or bonds that were dogs. But if they thought the deals they put their names on were sucky — and there sure is evidence that they did — then the basic discipline of maintaining a valued reputation, which deregulation has assumed would be our primary protection for the system, has in fact failed us, and failed spectacularly.

    So I’m trying to tease out why GS looked at Levin like he was crazy when he suggested that you don’t sell sucky deals to investors. And in fact, if we weren’t dealing with something labelled derivatives but were talking about something clearly labelled securities, there ought not to be any question that Levin is right. The system isn’t working properly if, depending on how one defines a transaction, there’s a loophole large enough to drive a freight train through and produce such an absurd result. “No, Senator, we had no problem selling deals we thought sucked! It was good business.” Yikes!!!

    You said in reply to my earlier comment: “You say: “the underwriter is negotiating on behalf of potential buyers who will discount the price or not buy the deal if their expectations re the sellers’ incentives aren’t met. Just as with final pricing of a deal, it’s another example of the underwriter’s natural ‘conflict of interest’”

    1. Wrong. The underwriter in your example is acting in its capacity as investment banker, advising the issuer on how to structure a transaction to obtain capital at a desired price on the capital markets.”

    First, I agree completely that “conflict of interest” is not per se evil, nor do I think I suggested such. I was pointing out that 1) conflicts are inevitable and built into the very structure of the securities business, and 2) depending on the nature of the deal and the type of conflict, we have historically had a range of methods (both legal/regulatory and standard market practices) for managing those inherent conflicts.

    An underwriter is inherently in a conflicted position — that’s what an investment banker does for a living, and the really successful ones produce both satisfied issuers and investors. True, the investment banker’s primary duty is to his client, the issuer. But he’s also going to have to sell the deal – and sell it honestly and with full disclosure of all the risks (that’s why we have 10b-5) and with the intention that the buyer will be willing to buy a future deal from him. So the investment banker is in effect sitting in the potential buyer’s shoes when he negotiates the structure (like lock-ups and clawbacks) and the price with the client. And if the deal isn’t “best efforts”, the underwriter is going to have to eat anything he can’t lay off, so he’s well and truly the buyer in that case. By definition, therefore, the investment banker always wears two hats, and we have a variety of laws, rules and market practices that help to manage that inevitable tension.

    I intentionally used a casual lingo to describe the elaborate and technical mix of standards of responsibility that apply to the various roles broker-dealers and underwriters play vis a vis the other various players at each step of any given transaction in the primary or secondary markets. For my purpose — which is to look at where policy may not be working adequately — I’m trying to get at the underlying relationships. In distinguishing between the economic role of a market-maker (which GS claims it was performing) and the economic role of an underwriter (which IMHO GS was in fact acting as), the precise legal grounds for each type of responsibility/duty/standard of care/contractual obligation don’t really make a whole lot of difference. You are, however, certainly correct that the technical grounds for imposing civil or criminal liability would be critical for framing a specific cause of action vis a vis GS by either the government or a party to a GS deal. It wouldn’t surprise me at all if GS turns out not to have any liability in the Abacus deal.

    From a policy standpoint, however, what Levin was asking is quite pertinent and really merits our close attention. During this period (2005-07), GS had in fact taken a decision to get rid of their housing inventory. A fact it appears they didn’t tell the folks they sold junk to when their bond salesmen were selling off their inventory or, it appears, when they were structuring deals.

    Just how big a responsibility they have to their buy-side clients when they’re selling to them in the secondary market remains to be seen — it’s a pretty low standard, unless their salesmen were making representations about the quality of the bonds that were false or misleading. So they probably don’t have much in the way of legal liability — just their reputation is in the crapper.

    [And, as an aside, just to be clear. I’d be horrified if Susan Collins’ suggestion of a “fiduciary duty” was applied to broker-dealers (either in their sales or trading functions). The securities market couldn’t function with that degree of potential exposure to broker-dealers. Though I do think the suitability requirement could be both expanded (e.g. municipal treasurers are proven NOT to be “sophisticated” investors) and tightened up. But that’s relatively minor and nothing like what Collins seemed to be suggesting.]

    But when it comes to selling a deal the intermediary itself is responsible for structuring, the standards are (or should be) definitely higher. And if GS thought the stuff going into the vehicles they were structuring was shitty, that needed to have been reflected in the disclosure of risks and the pricing. Maybe it was, maybe it wasn’t. But it sure didn’t sound from the testimony before the Senate that GS thought it had any particular responsibility beyond “bringing buyer and seller together”.

    Btw — you say price discovery is this wonderful side benefit, but just how was a deal like Abacus priced anyhow? Did the buyer have any truly independent way to evaluate the price or were they just a price taker, based on GS’s supposed expertise in the derivatives market? The yield pick-up looked attractive for a AAA tranche, end of discussion.

    Please note, I haven’t an ounce of sympathy for ACA who were at best incompetent or, for that matter, for the portfolio managers who were the ultimate investors, who seem to have violated their own fiduciary duties to their beneficiaries. A plague on all their houses. BUT, as a matter of policy going forward, I think we need to apply to the derivatives-related business the sorts of standards that are (or at least were decades ago) common place in the equity and bond business.

    Now, as for Chinese walls. These are old, old methods for managing conflicts, but during the internet (and other finanancial shenannigans) bubble they weren’t being managed properly or folks were end-running them. So the rules were strengthened in the aftermath of the analysts scandals. But from a practical standpoint, the purpose of Chinese walls is primarily to keep the traders from having info about possible deals that might move the market or allow them to benefit from inside info. So the folks who are in a position to move markets with their info (analysts, investment bankers) can’t cross the wall and contaminate the sales and trading functions. Similarly, the trading function can’t influence, for its own benefit, the services the analysts and investment bankers are supposed to be providing to their clients. That being said, the underwriter function definitely needs to know the sentiments of the folks who are selling or trading in order to structure and price a deal — and at a certain point, information has to flow just to complete due diligence, in case the trading side has material negative information that would need to be disclosed. So there are information flows (up the ladder to senior management and to the investment bankers that box out the salesmen and traders). These flows are necessary to protect the firm from underwriting a deal which would conflict with the position the firm is otherwise taking in the markets — which in an equity deal would cause a scandal with both the client issuer and the investors – or from exploiting inside information. In equity offerings, there are also rules that govern how the trading desk can behave immediately before and during the weeks after an offering, which at least in theory keep the firm from being able to front run, or to trade against the interests of the investors in the deal, or to ramp up the immediate after-market price while they’re selling off their allotment. So with Chinese walls, the trading side isn’t polluted by the investment banking side. But equally important, the point I was making is that as a practical matter, a new issue of shares or bonds won’t get done if the trading side is acting in, or taking a position, in opposition to the issuer or investors.

    All of the old-fashioned practices had long governed the equity markets (and to a lesser extent the bond markets, given to the limited amount of secondary bond trading). But it seems that the moment the word “derivatives” was introduced, the banks claimed that all the old rules didn’t apply. According to GS, Chinese walls are irrelevant for derivative-related deals because everything is on the market-maker side of the wall. They were just passive middle men, bringing buyer and seller together, and could take any old position for their own account regardless of the interests of any of the folks they were bringing together. Even if they were responsible for putting together and structuring the deal, they didn’t owe any greater responsibility than if they were making a market by responding to a bid or ask.

    I just read a comment on the Conglomerate Blog that captures some of my concerns as well as points to the past as instructive for how we might manage things better in the future. The commenter, “Lucy Honeychurch” reminds us that “NYSE Rule 98 was designed to ensure that NYSE Specialists (downstairs market makers) were prohibited from doing an upstairs business due to the informational inequalities that exist in favor of a market-maker who, naturally, sees the whole book. It stipulates that their primary objective – above all else – is to maintain a fair and orderly market in the securities in which they make a book.

    With the repeal of Glass-Steagall, the proliferation of OTC trading, the concerted focus on deregulation, and the evolution of a wholly unregulated market in derivatives – it seems we are ripe to revisit the principles that underlay some of the oldest regulation on the books – like NYSE Rule 98.” The rest of her comment is worth reading.

    The stuff GS was talking about before the Senate didn’t look, smell or quack like any “market maker” I’ve ever seen. Technically, they may have a point that they were legally operating in a “market-making”, not an underwriting capacity. But that’s not the sort of activity the market-maker or secondary market rules were designed to handle. Which is the point (or one of them) Levin made.

    Under any sustainable financial system, which depends on some basic standards of good faith performance, GS should have been subject to a professional obligation higher than the one they felt they were subject to. And GS simply didn’t have an adequate response. How could they!?!

  58. Kwak. Obviously you don’t come here much, or this is the first time.

  59. In my estimation, generally the derivatives market is meaningless in the context of the real economy. It is an essential part of the casino economy, of course. Further, my opinion is that CDO’s, CDS’s and synthetic CDO’s should just be eliminated (the CDS’s only as they relate to financial products, except interest rate swaps for borrowers who are not a part of the financial market place and as to other non-financial commodities).

    These synthetic CDO’s are demonic and have no place in the financial marketplace. They are casino gaming tools (which favor the house, always, just like any casino game does). They are absurd constructs, useless to the general populace.

  60. notabanker,

    count me in on that one. I think the general stance on such products should be one of ‘Comply or Explain’. Meaning that products sold should either be proven compliant to the general ‘attributes of an acceptable derivative’ (concerning management, disclosure, underlying assets …) and ticked, or unticked AND BEING REQUIRED to clearly state so. One might, in the latter case, also require that the unticked product declare in what aspects it is non-compliant.

    Though i think this should be the general direction to go, one also has to notice that the market will always be ahead of regulation. Financial ‘products’ in a broad sense can be made as complex as needed, especially by mixing in risk/statistics at will.
    This opened the door for the diversification, ‘mimicing’ and ‘rating’-strategies used to fool the buyers.

    Firms and institutions need some smart people in regulation to be as much on-par with the markets as possible. New products/product-attributes in this important market should be noted and analyzed to their virtue/dangers so the ‘proofing-attributes’ stay up to date.

    In a casino at least the chips are real …

  61. @CBS from the West. Thanks, though my explanation didn’t appear to satisfy Amos. However, with respect to your larger issue of basic business ethics, I do think that the market-maker/underwriter distinction I raised is an important one. Although I certainly agree that our society will continue to be harmed if people can’t expect a basic reciprocity of good faith financial dealing, I’d ask you to think just what the cost would be of trying to enforce appropriate ethical rules.

    In the secondary or trading market, a buyer has an opinion about the price he is willing to pay for something, based on whatever research or analysis he’s done or rumors or CNBC tips he’s heard. The seller similarly has an opinion about what he’s willing to sell for. They meet (most often anonymously) in the marketplace and do their business. It doesn’t matter who is on the other side of the trade as long as each is in a position to deliver the thing being sold or the purchase price. The fact that one side of the trade is a sophisticated financial institution and is more likely to have superior information and analysis than a day-trader doesn’t change anything. And if the financial institution is acting as a market-maker, his business is simply to use his view of the market to be able to stand ready to buy or sell in order to make an orderly market, regardless of his personal opinion about the ultimate true value of the things being traded. As long as we keep manipulative activities out of the secondary markets, trading systems work pretty well. They would come to a screeching halt if anyone who lost money on a trade could sue the guy on the other side because the seller got a good price for what the seller thought was junk.

    However, when a financial institution is peddling securities — either as an underwriter in a new issue, or as a broker calling up an investor with a proposed deal for securities that have already been issued — we impose higher legal responsibilities on the financial institution.

    When it comes to selling already-issued securities (secondary market), the responsibilities aren’t huge. First, the salesman can’t make false or misleading representations — that’s garden-variety fraud. So if he’s trying to unload something he thinks is a piece of junk, he can’t lead the client to believe it’s a great deal. And if the investor is a retail investor (e.g. isn’t high net worth), the broker has some affirmative obligations to “know his customer” and not sell investments that are unsuitable for the customer.

    But our system assumes that the big boys on the buy-side can fend for themselves. And IMHO, that’s generally as it should be. If the big boys turn out to be lousy investors who naively bought anything GS wanted to sell them and blew the savings of widows and orphans, we need to impose higher standards on the big boys (or on the rating agencies on which they rely). If, instead, our legal system was set up to second-guess the broker-dealers who sold securities that didn’t turn out to be great investments, we’d have a messy, uncertain system that would be enormously inefficient and excessively costly.

    Furthermore, if a financial institution gets a reputation for peddling garbage, one assumes its clients will soon find other firms to do business with. That’s the risk GS is now facing after the past week of awful disclosures of what are almost entirely self-inflicted wounds. And it’s not just buyers who may now be concerned that GS will screw them. Any portfolio manager who continues to buy from GS will worry whether he himself might be second-guessed for continuing to do business with them.

    All that is secondary market stuff — the financial institution has a fairly modest responsibility not to defraud one’s customers or, with respect to retail clients, not to unscrupulously take advantage of them. As a policy matter, we should probably improve the ability of small customers to enforce their rights against unscrupulous brokers, but that’s not a systemic concern.

    However, the level of responsibility to the investor is and should be greater when the financial institution is underwriting a new issue (a primary offering). This is because the underwriter is in a unique position to be informed and has a unique role vis a vis both the issuer and investors.

    As I argued to Amos, in effect the investment banker is representing the buyer to a limited extent. So at a minimum, we require the underwriter to investigate the deal (do due diligence) to satisfy himself that he knows everything he’d want to know if he himself were making the investment, AND disclose all of that relevant information to the potential investors. And in this situation, the “sophistication” or lack thereof of the investors is irrelevant to the responsibility we impose on the underwriter.

    Now, it’s true that if the investor is “sophisticated” and there are only a small number of investors in total (a private placement as opposed to a public offering), the amount of affirmative information which has to be disclosed is abbreviated — one reason being that the investors are assumed to be capable of performing a portion of their own due diligence. That’s obviously one of the defenses GS will use in the Abacus deal. But that doesn’t relieve the underwriter of the responsibility to perform his own due diligence and disclose material negative information in the underwriter’s possession.

    And that’s where I agree fully with your position that, “the business model underlying this type of transaction is nothing more than parting fools from their money. As long as that remains a dominant business model… our future will be dismal.” But, watch how far you take what is an ethical standard when it comes to legal standards. We don’t want to impose that standard as a legal rule on all financial transactions.

    Think of it this way. We don’t want to have to investigate the knowledge or intentions of buyers and sellers who meet in a market to trade things. No sale would ever be final if any unhappy buyer could challenge the seller’s good faith, and the costs of investigation would be prohibitive. So as long as the thing sold is in fact what the buyer expected to purchase, we say basta.

    Once the seller starts soliciting the buyer’s interest, however, there’s more opportunity for the seller to engage in practices we want to discourage. So we impose higher responsibilities on the seller — for example, he can’t provide false or misleading information about the thing being sold. The seller’s responsibilities are increased when the information asymmetries and/or bargaining power are to the seller’s advantage. So we impose higher standards on the seller when the buyer is likely to be unsophisticated or if the buyer has only a small amount of savings, the loss of which would produce severe economic consequences for the individual. We also impose higher standards on the seller when he is the principal vehicle through which the potential buyer can inform himself about the proposed purchase — when the seller is underwriter and is, for certain purposes, in effect standing in the buyer’s shoes. We don’t impose the full responsibilities of being an agent on the underwriter, but we do adjust upward the standard of accountability the underwriter has to the buyer for the quality of what is being sold.

    When deciding what the legal standards should be and how to enforce them, we need to be concerned with the efficiency of the marketplace, like whether it would undermine the finality of deals, and the costs of enforcing the rules, like whether it would require expensive litigation to determine the mindset of a seller or whether providing more disciplines on the buyer if he’s a big boy (or on the rating agencies) would be more likely to produce reasonably safe markets.

    It’s a matter of trade-offs, and the system will never be perfect. Our system of rules won’t work, however, if it’s not supported by a broad culture that identifies certain types of behavior by prestigious firms — like selling “defective goods” or treating clients as stool pigeons — as unacceptable and shameful behavior. As the past couple of years have shown, we seem to have lost any such sense of what sorts of behavior are praiseworthy and what are to be universally condemned. Public shaming of GS is at least a first step.

  62. markets.aurelius

    So in fighting “section 106″ requiring the hiving off of its derivs trading units, GS essentially says it needs the full faith and credit of the US govt behind it to do this sort of thing? This is what unconditional backing of the govt gets us? This is the new economy? These are the new companies that tax dollars are supporting? These companies are the new employers of the army of unemployed in America and around the world right now?

    Where is the money for the rebuilding of the American economy, the European economy and the emerging-market going to come from if this is the end to which governments’ tax revenues are being directed? How is the enrichment of a few thousand people at an annual rate that is multiples of the bailouts of Greece in any way consistent with the sound use of taxpayer funding, and the imprimatur of the full faith and credit of the host governments?

    Have a look:

    http://online.wsj.com/article/SB10001424052748703648304575212630476857628.html?ru=yahoo&mod=yahoo_hs

  63. (1)”So the buyers of the securities CANNOT have thought that GS had a duty to them beyond GS’ duty as an underwriter not to make a materially misleading statement in the prospectus.”

    Not disclosing material facts is as fraudulent as making misleading statements. See Reg 10-b.

    (2)”Therefore the buyers knew that SOMEBODY was on the other side of the trade….So whatever ‘conflict of interest’ there was cannot have been a HIDDEN conflict.”

    The first assertion is tautological & hence irrelevant to any discussion of anything. The second assertion renders the notions of fraud and misrepresentation logically impossible, in this context or any other.

    (3) An extended “discourse” on the tautology of (2).

    (4) You assert that derivative contracts which are “too illiquid to create price visibility” on CDO-like risks” are nonetheless socially useful in price discovery.

    Though unrelated to the SEC-charges issues in the GS case, this is an interesting perspective; but not one related at all to synthetic, synthetic CDOs in general or to this one in particular. For CDOs cubed, the indirect price discovery justification argument might work IF the method of synthesizing the CDSs on the reference entities–the full dynamic hedging algorithm(s)–were fully known by all transacting parties. Then they would–in principle–be able to assess just how “CDO-like” the risks were. Absent such disclosure of prop-trading secrets, the indirect price discovery argument could work if GS, e.g., put up hard collateral to guarantee that its CDS synthetics performed precisely as a real world, liquidly-traded CDSs do. At least then, one could be defending the social utility of a collection of products each of which actually acts likes a bucket shop product rather than of such a collection that might do so and whose potential failures in such mimicry would be quite unknown.

  64. Amos,

    Does not look like Goldman lawyers agree with your interpretation of responsibilities of an underwriter. Otherwise they would not like to present a structurer as a trader and claim that they were only market maker and not underwriter.

  65. @d4winds –
    (1) The claim is that ACA should have been told that there was someone on the other side of the transaction. That’s it.

    (2) & (3) See above.

    (4) What I assert is that even if a derivative is too illiquid for its sale to reveal much about the price of THAT derivative, the transaction still has a price discovery effect with respect to the underlying. Or, in a derivative-squared, the underlying-underlying, etc.

    This doesn’t require anyone to have visibility to a “full dynamic hedging algorithm.” It only requires that there was demand for what ACA bought — CDO risks in A tranches — which was partially satisfied by Abacus.

    That’s it.

  66. @nadezhda –

    You say: “It appears that the lion’s share of the CDS-related stuff created from 2005 onwards just inflated the amount of dodgy assets that were available to fuel the crash. There may have been (modest) price-discovery benefits from these deals, but given how much they amplified leverage, the system overall would have been much healthier if, in the aggregate, most of them had never been done.”

    Huh? I think you are confused. The “CDS-related stuff” could only exist because there was demand to purchase the other side of the transaction. The “CDS-related stuff” necessarily satisfied some of that demand, leading to price discovery.

    As for whether CDS’ “fueled the crash,” I think you have things reversed. The existence of a synthetic CDO (a CDS-backed CDO) implies the NON-EXISTENCE of some set of RMBS’, based on the NON-EXISTENCE of some set of housing loans, which otherwise would have had to exist for the purchaser of the synthetic to have acquired the same risk without the use of CDS’s.

    So the proliferation of shorting CDS’s and synthetic CDO’s would seem to be an impediment to the growth of the housing bubble.

    As for “evidence” of whether this took place, I don’t know how you get where you are. The housing bubble burst when the price of housing stopped going up, which happened contemporaneously with (after?) the explosion in CDS’s.

    Your post then has several dense paragraphs, the jist of which seems to be that you think that Abacus, or some other transactions, were “designed to fail.” This is, for reasons I and others have pointed out, and you have ignored, just weasel-words for saying that synthetic derivatives are zero-sum and necessarily create a winner and a loser. The rest of your argument on the subject, that the transaction was “sucky” or “shitty” or whatever, is just repetition of a pejorative that hides an intellectual error.

    You then pick-up the issue if whether GS was acting as an underwriter: “So the investment banker is in effect sitting in the potential buyer’s shoes when he negotiates the structure (like lock-ups and clawbacks) and the price with the client.”

    No. The investment banker is sitting in the position of a marketer, giving executives advice on what products to sell and how to package them.

    Then: “And if the deal isn’t “best efforts”, the underwriter is going to have to eat anything he can’t lay off, so he’s well and truly the buyer in that case.”

    Like I said, “very basic”… That just isn’t how underwriting works. I would try to explain this, but frankly I don’t have the time and I think anyone else reading this will understand the error.

    The claim that an underwriter’s position is “inherently conflicted,” or whatever, is just wrong.

    You then say: “For my purpose — which is to look at where policy may not be working adequately — I’m trying to get at the underlying relationships. In distinguishing between the economic role of a market-maker (which GS claims it was performing) and the economic role of an underwriter (which IMHO GS was in fact acting as), the precise legal grounds for each type of responsibility/duty/standard of care/contractual obligation don’t really make a whole lot of difference.”

    This is a repetition of the error. “Underwriter” and “Market Maker” are regulatory roles. One can act in the regulatory role of Underwriter while playing the economic function of -making-a-market- without inconsistency, and without assuming the regulatory role of Market Maker.

    Later: “The stuff GS was talking about before the Senate didn’t look, smell or quack like any “market maker” I’ve ever seen.”

    I don’t think you’ve seen much. Your writing is filled with confusion about how financial transactions are executed and the different legal regimes and economic roles that intermediaries can play.

    I think you’re a student. An intern, or 2d year banker or lawyer at best.

  67. @rm: You’re repeating the same confusion that these roles “underwriter,” “market maker,” etc. are somehow contradictory.

    Someone playing the regulatory role of “Underwrter” can make a market. That is true whether or not they are playing the regulatory role of “Market Maker.”

    If I hold myself out as making a market in housing risks, and people call me to buy and sell those risks, and I put those people together, then I’m making a market. This is true even though there is no exchange and I am therefore not a regulatory Market Maker.

    If the mechanism by which I connect buyer and seller sometimes involves the creation of new securities, in which I play the role of underwriter for a new special purpose entity created to facilitate a transfer of risk from seller to buyer — so what? The rule is that an underwriter is NOT a fiduciary, precisely so that banks CAN engage in transactions like this without people whining about “conflicts of interest.”

  68. Amos’ defense yesterday at 10:48:

    “Free societies, however, are defined by the presence of “negative rights.” That is, we can do something in the absence of a rule forbidding us from doing so. We do not need to ask the government’s permission before acting.”

    Agreed. But that’s not what happened here. GS and others FIRST made sure that the existing rules, which would have classified these kinds of bets as either illegal gambling or illegal insurance, would NOT be enforced. So you are simply wrong: GS and others in their industry did NOT create something entirely new and legal, they created something entirely new that would have been ILLEGAL without first obtaining government permission.

  69. I think it’s pretty clear that the abacus structure was an arb against the cdo rating model as much as anything else. Full disclosure should have been — ” this deal is put together to maximize the following suspected inefficiencies in the cdo aaa rating model, and the subsequent tranch pricing, relative to the market value of the underlying basket of cds.”. yeah right …. Fab admitted to having access to the rating models, does anyone think he was not gaming them to advantage the short interest?

  70. Doug Anthony

    Just think of all those fees originating out of thin air – sure beats trading risk!

  71. Bill Gilwood

    Good comments. What purpose do these CDO’s, CDS’s and other such garbage serve, other than to churn money and put the entire economy at risk while making a few people very rich? Why not just declare them null and void and be done with it?

  72. Patrick, you say in part:
    ‘one also has to notice that the market will always be ahead of regulation.’

    Dead right but if the market is offering both:
    a. ticked (ie. regulators have evaluated) and
    b. unticked (caveat emptor)
    then regulators being behind the curve and crooks trying to cheat people will be clear. If you buy an unticked derivative, you only have yourself to blame if something fails.

    Seems a much easier market scene to manage? It would be interesting to see a derivatives expert comment on practicality of this suggestion versus attempting to develop a universal set of regulations and/or market restrictions? Are you there StatsGuy?

  73. shoot fun story man.

  74. Ponzi leveraging scheme.

  75. @ Amos

    I think you are over-complicating the issues here and losing sight of the big picture.

    The security sale at the heart of the SEC’s alleged fraud is not a zero-sum derivative. It is a vanilla BOND (rated AAA), which sits on the liability side of the balance sheet of some legal entity. The fact that the business model of the legal entity is “to try to make money through fancy positions in zero-sum derivatives as long as the housing market boom lasts” does not make the security in question a zero sum game and it does not make Goldman Sachs into a broker. Goldman was clearly an underwriter in this case, and they misrepresented the identity of the issuer, the incentives of the true issuer, and material facts which would have helped the buyer of the bonds to better evaluate the prospects of success of the business model (and therefore the chances of the bond being repaid)

  76. @George – No, I have the big picture. You are confusing one slice of the transaction for the whole, and misunderstanding the deal the purchasers made at the time of the purchase.

    The bond issuer was a special purpose entity that had no assets and, indeed, no existence before the transaction. But, the buyers still did the deal as though the bonds had the same (perceived) creditworthiness as the underlying instruments they were supposed to track. If the issuer had no assets, how could this be? How could the buyers believe that the issuer would be able to pay?

    The answer is that the buyers cannot have thought the issuer was a layer of credit risk. They must therefore have believed –correctly– that someone was on the other side of the transaction. I have no doubt that the transaction documents contain representations to that effect.

  77. @ George :

    And one other thing — your post is filled with claims that GS made “misrepresentations” of one form or another.

    Those are not accusations the SEC has made. They are not accusations the buyers have made. Do you have any justification or basis for making those accusations?

    Those are real human beings you are accusing of criminal fraud. Do you have a basis in facts for accusing those people, who have parents and siblings and wives and families, of being liars and crooks? Did you just say it because it sounded good?

  78. @ Amos

    The big picture that you are missing is that it doesn’t matter how many or how exotic the derivatives inside the SPV were. GS did not sell those derivatives. It sold claims to cash flows that would be thrown off by the SPV itself. So GS basically sold to IKB a bond issued by a new legal entity with some exotic business model related to derivatives. That new legal entity had a balance sheet, and that balance sheet most certainly did have an asset side (ok an exotic asset side) as well as a liability side.

    As for your second post, I read all 22 pages of the SEC complaint against Goldman. First, I did not accuse Goldman of criminal fraud as you stated(mens rea and all that) but I did accuse them of “misrepresentation”. Second, all three of my misrepresentation claims were sourced from that SEC document. However, to clarify my post above, by my first point (misrepresentation of the identity of the issuer) I was referring to ACA’s role as a supposedly independent and credible 3rd party mortgage manager (a key point that bond-buyer IKB had insisted on) when in fact ACA had compromised its independence by accepting Paulson’s choices. So ACA was not a substantial part of the issuer, but really just a rubber-stamp/front piece that was needed to make the issuer appear different (in critical qualities) than what it actually was. Apologies if my choice of words (“misrepresentation of the identity of the issuer”) confused you there.

  79. @George –
    The software is not letting me put a reply below your post so I will put it here.

    You say ” That new legal entity had a balance sheet, and that balance sheet most certainly did have an asset side (ok an exotic asset side) as well as a liability side.”

    The “asset side” of the entity was the person on the other side of the trade. That person was either a GS client, or it was GS itself. As a matter of simple logic, there is no third option. ACA and IKB were aware that someone was on the other side of the trade. It would be impossible not to be aware of it.

    Moreover — ACA’s BUSINESS was selling insurance on bonds, which is exactly the economic structure of this transaction, a sale of bond insurance to Paulson.

    On your second point – your post says that GS misrepresented the identity of the issuer. That would surely be a criminal fraud if true. The SEC does not say what you say they say.

    Beyond that, you are confusing the roles of ACA and GS. ACA was the buyer or worked for the buyer (depending on how one looks at it). ACA was not the issuer or the seller.

  80. @Sean
    The old-fashioned practices had stressed governed the equity markets (and to a lesser extent the enslaved markets, conferred to the qualified quantity of indirect connecter trading). But it seems that the second the articulate “derivatives” was introduced, the phytologist claimed that all the old rules didn’t touch. According to GS, Chinese walls are immaterial for derivative-related deals because everything is on the market-maker take of the paries. They were meet unresisting middle men, transferral vendee and marketer together, and could train any old situation for their own accounting regardless of the interests of any of the folks they were transportation together.

  81. Milo Minderbinder

    Amos is absolutely correct.

  82. Logical fallacy alert:

    1. “we can do something in the absence of a rule forbidding us from doing so”. The question of the legality of the transaction is still open, at least as long as the investigation is going on. You have argued for it, you have not proven it. Assuming you have is begging the question.

    2. Jeffrey made the point that the usefuleness of the CDO cubed innovative features is questionable. He didn’t say “illegal” or imply it in any way. The legality of the transaction was not questioned, the morality (in a utilitarian context) was. Morality does not equal legality therefore invoking the negative rights of a free society is a clear non-sequitur.

    Rest assured, the idea freedom is safe from baseline scenario commenters, although I can’t say the same about logic.

  83. @ Amos

    With those SPV’s, the identity of the issuer (after lifting the corporate veil) is the identity of the holder of the lowest (or “equity”) tranche)

    When Paulson was presented to ACA and potentially IKB as “being net long $200m” he was thus being presented as the implied issuer. Note in the SEC document the failure of ACA to ask too many questions on the matter.

    But Paulson was not net long, he was net short several times more than $200m. That is what I meant when I said that [Paulson]’s identity as the issuer was misrepresented.

    As for the balance sheet of the SPV, your answer was weak. Having people on balance sheets amounts to slavery, so that is not possible.

    You keep writing paragraphs of comments, but you have still not put up a convincing answer to my point that in essence Goldman was acting as an underwriter peddling AAA vanilla bonds and therefore that its entire defence (“we were marketmakers”) goes out of the window.

  84. @Amos

    One last example to show you where your argument goes astray.

    If Goldman had created, say, an index that rises and falls with the US housing market.

    If Goldman had created futures contracts on that index, and offered bid/ask spreads to all comers.

    If IKB had gone long some of those index futures, knowing full well that someone (even Goldman itself) was taking the other side of that bet (mathematical necessity)

    THEN Goldman would have been a marketmaker and would not have owed any duties to IKB except the standard, secondary execution and best price duties.

    But THAT IS NOT WHAT GOLDMAN DID.

    Goldman and Paulson created a new legal entity with a business plan to make some money off the housing market, and sold AAA rated bonds in that new legal entity. Therefore, Goldman was in the primary market, selling securities as an underwriter, and bearing the burden of full disclosure of material facts to the buyers.

    Amos, all your points would be correct if we were in the secondary world where Goldman had created an index and acted as a market maker. But Goldman didn’t do that at all. They were after AAA money, and they did what they had to do to get fools to part with it. Which, in the end, probably broke securities laws. I wonder what is your reply to this specific point, Amos.